Is a 401(k) Worth It for Your Retirement Savings?

A 401(k) is a popular employer-sponsored retirement savings plan that allows individuals to save for their future on a tax-advantaged basis. This article explores the fundamental aspects that contribute to a 401(k)’s value.

How a 401(k) Can Grow Your Savings

A primary advantage of a Traditional 401(k) is its tax-deferred growth mechanism. Contributions made to a Traditional 401(k) are pre-tax, meaning they reduce an individual’s taxable income in the year they are made. The investments within the account then grow, and earnings are not taxed until retirement, allowing the full amount to compound over many years. This deferral of taxes can enhance the growth potential of savings.

The power of compounding is a significant factor in how a 401(k) builds wealth over time. Compounding refers to the process where investment earnings generate their own earnings. Even consistent, relatively small contributions made early in one’s career can accumulate into substantial sums over decades, as both the principal contributions and the accumulated earnings continue to grow. This exponential growth illustrates the benefit of starting to save as early as possible.

Employer matching contributions represent a direct and immediate boost to savings, often considered “free money.” Many employers contribute a percentage of an employee’s salary to their 401(k) plan, provided the employee also contributes a certain amount. For instance, an employer might match 50% of an employee’s contributions up to 6% of their salary, effectively doubling the employee’s savings on that portion. Failing to contribute enough to receive the full employer match means missing out on this valuable benefit.

Beyond Traditional 401(k)s, some employers offer Roth 401(k) options. With a Roth 401(k), contributions are made with after-tax dollars, meaning they do not reduce current taxable income. However, qualified withdrawals in retirement, including all earnings, are entirely tax-free. This structure provides flexibility and can be beneficial for those who anticipate being in a higher tax bracket during retirement. Both Traditional and Roth 401(k)s offer distinct tax advantages that contribute to long-term savings growth.

Key Rules for Contributions and Withdrawals

The IRS sets annual contribution limits. For 2025, individuals can contribute up to $23,500 to their 401(k) plans. This limit applies to employee salary deferrals, whether to a Traditional or Roth 401(k).

For those aged 50 and over, additional “catch-up” contributions are permitted, allowing them to contribute more to their retirement savings. In 2025, individuals aged 50 and older can contribute an additional $7,500, bringing their total maximum contribution to $31,000. The total combined employee and employer contribution limit for 2025 is $70,000, or $77,500 for those aged 50 and over including catch-up contributions.

Accessing 401(k) funds before age 59½ incurs a 10% early withdrawal penalty, in addition to regular income taxes on the withdrawn amount. However, certain exceptions to this penalty exist. These include distributions made due to total and permanent disability, unreimbursed medical expenses exceeding a certain percentage of adjusted gross income, and distributions made to beneficiaries after the account holder’s death.

One notable exception is the Rule of 55, which allows individuals who leave their job during or after the calendar year they turn 55 to take penalty-free withdrawals from the 401(k) plan of that specific employer. This rule applies whether the separation from service is due to resignation, termination, or retirement. It is important to note that this rule applies only to the 401(k) from the employer from whom the individual separated, and not to IRAs or 401(k)s from previous employers.

Required Minimum Distributions (RMDs) are mandatory withdrawals that must begin from Traditional 401(k)s and similar tax-deferred accounts once an individual reaches age 73. These distributions ensure that taxes are eventually paid on the deferred income. Failure to take the full RMD by the deadline can result in a significant penalty. Roth 401(k)s do not have RMDs for the original owner during their lifetime.

Another way to access funds from a 401(k) is through a 401(k) loan. Unlike a withdrawal, a loan must be repaid. The maximum amount that can be borrowed is the lesser of $50,000 or 50% of the vested account balance. These loans must be repaid within five years. If a 401(k) loan is not repaid according to the terms, the outstanding balance may be considered a taxable distribution and subject to the 10% early withdrawal penalty if the individual is under age 59½.

Making the Most of Your 401(k)

Selecting appropriate investments within the plan’s offerings is important. Diversification across different asset classes, such as stocks and bonds, is recommended to mitigate risk and align with individual risk tolerance and financial goals. Many plans offer a range of mutual funds, exchange-traded funds (ETFs), or target-date funds, which automatically adjust their asset allocation over time.

Minimizing fees associated with the plan and its investments is important, as these can erode returns over time. 401(k) fees can range from 0.5% to over 2% of plan assets annually and include administrative fees and investment management fees.

When changing jobs, individuals have options for their former employer’s 401(k) funds. They can roll over funds into an Individual Retirement Account (IRA), which provides broader investment choices and lower fees. Another choice is to roll over funds into a new employer’s 401(k) plan, if accepted. Individuals may also leave funds in the former employer’s 401(k) plan, especially if it has low fees and strong investment options.