In What Way Does a 401(k) Differ From Other Retirement Accounts?
Understand how a 401(k) compares to other retirement accounts, including its tax benefits, employer involvement, and withdrawal rules.
Saving for retirement involves choosing the right type of account, each with its own rules and benefits. A 401(k) is one of the most common retirement plans, differing from IRAs and pensions in key ways. Understanding these differences helps individuals make informed financial decisions.
A 401(k) stands out due to employer involvement, contribution limits, tax advantages, withdrawal rules, and portability. These factors determine how much can be saved, when funds can be accessed, and what happens if an employee changes jobs.
Employer Sponsorship
A 401(k) is an employer-sponsored plan, unlike IRAs, which individuals can open independently. Access depends on whether an employer offers one as part of its benefits package. Employers work with financial institutions to manage these plans, selecting investment options and ensuring compliance with federal regulations.
A major advantage is employer matching contributions. Many companies match a portion of employee contributions, effectively boosting retirement savings. For example, an employer might contribute 50% of an employee’s contributions up to 6% of their salary. Some companies require employees to stay for a certain period before receiving the full match.
Employers also determine available investment options. While IRAs allow a wide range of assets, 401(k) plans generally offer a limited selection of mutual funds, target-date funds, and sometimes company stock. This simplifies decision-making for employees who may not have extensive investment knowledge. Some plans include automatic enrollment and escalation features, which gradually increase contributions unless the employee opts out.
Contribution Limits
The IRS sets annual contribution limits for 401(k) plans, adjusting them periodically for inflation. In 2024, employees can contribute up to $23,000, with an additional $7,500 in “catch-up” contributions for those aged 50 and older, bringing their total to $30,500. These limits are significantly higher than those for IRAs, which cap contributions at $7,000, or $8,000 for those eligible for catch-up contributions.
Total contributions—including both employee and employer contributions—cannot exceed $69,000 in 2024, or $76,500 for those eligible for catch-up contributions.
Unlike IRAs, which impose income-based restrictions on Roth contributions, a 401(k) allows high earners to contribute regardless of income. However, some plans are subject to IRS nondiscrimination testing to ensure highly compensated employees do not receive disproportionate benefits. If a plan fails these tests, contributions from high earners may be limited or refunded.
Tax Treatment
A 401(k) offers tax advantages that apply to both contributions and withdrawals. Traditional 401(k) contributions are made with pre-tax dollars, reducing taxable income for the year. Investments grow tax-deferred, meaning dividends, interest, and capital gains are not taxed until withdrawal.
Roth 401(k) contributions, by contrast, are made with after-tax dollars and do not lower taxable income in the contribution year. However, withdrawals—including earnings—are tax-free in retirement, provided the account holder is at least 59½ and has held the account for at least five years. Unlike Roth IRAs, Roth 401(k)s have no income limits, allowing high earners to take advantage of tax-free growth.
Required Minimum Distributions (RMDs) apply to traditional 401(k)s starting at age 73. The required amount is based on IRS life expectancy tables, and failing to withdraw the correct amount results in a penalty of 25%, which may be reduced to 10% if corrected within two years. Roth 401(k)s were previously subject to RMDs, but this requirement was eliminated in 2024, allowing funds to remain invested indefinitely.
Vesting Schedules
Employer contributions to a 401(k) may be subject to a vesting schedule, determining when employees gain full ownership of those funds. Personal contributions and their investment gains always belong to the employee, but employer contributions may have restrictions.
There are three main types of vesting: immediate, graded, and cliff. Immediate vesting grants full ownership of employer contributions right away. Graded vesting increases ownership gradually, such as 20% per year over five years. Cliff vesting requires employees to stay with the company for a set period—often three years—before gaining 100% ownership all at once.
Federal regulations set maximum timeframes for vesting schedules. Cliff vesting cannot exceed three years, while graded vesting must reach full ownership within six years. Employers use these schedules to encourage long-term retention.
Distribution Protocols
Withdrawing funds from a 401(k) follows strict rules to encourage long-term savings. Standard withdrawals begin at age 59½ and are taxed as ordinary income if taken from a traditional 401(k). Early withdrawals generally incur a 10% penalty in addition to income taxes, though exceptions exist.
One exception is the “Rule of 55,” which allows penalty-free withdrawals for those who leave their job at age 55 or older. Hardship withdrawals permit access to funds for specific financial emergencies, such as medical expenses or home foreclosure prevention, though they must meet IRS criteria.
Some 401(k) plans allow loans, letting participants borrow up to 50% of their vested balance, with a maximum loan amount of $50,000. These loans typically must be repaid within five years, with interest paid back into the account. If an individual leaves their job before repaying the loan, the outstanding balance may be treated as a taxable distribution, potentially incurring penalties. IRAs do not permit loans.
Rollover Procedures
When changing jobs or retiring, individuals must decide what to do with their 401(k) funds. Unlike pensions, which provide fixed payouts, 401(k) plans require active management when transitioning between employers or entering retirement.
A direct rollover to an IRA allows funds to be transferred without taxes or penalties, offering greater investment flexibility. Another option is rolling funds into a new employer’s 401(k) if the plan allows transfers. This can simplify account management and maintain access to loan provisions, which IRAs do not offer.
Leaving funds in a former employer’s plan may be possible, though companies may require accounts with less than $5,000 to be transferred or cashed out. Cashing out a 401(k) is typically the least favorable option, as it triggers income taxes and a 10% penalty if the account holder is under 59½, significantly reducing retirement savings.