What Are the Rules for a 401k Plan?

A 401k is a retirement savings plan offered by many American employers that provides tax advantages. These plans are governed by federal law, primarily the Employee Retirement Income Security Act of 1974 (ERISA), which sets minimum standards to protect participating employees. The Internal Revenue Service (IRS) also establishes the rules for contributions, distributions, and loans. While employers have flexibility in plan design, such as offering matching contributions, they must adhere to these foundational regulations.

Contribution Rules

The IRS sets an annual limit on the amount employees can defer from their paychecks into a 401k. For 2025, this employee contribution limit is $23,500. This cap applies to the total amount an employee can contribute across all 401k plans they might have.

To help individuals increase their savings, catch-up contributions are permitted for those nearing retirement. Individuals age 50 or over can contribute an additional $7,500 for 2025. A newer provision allows those aged 60 through 63 to make a higher catch-up contribution of $11,250.

Participants often have a choice between two types of contributions. Traditional 401k contributions are made on a pre-tax basis, lowering current taxable income. Roth 401k contributions are made with after-tax dollars, meaning qualified withdrawals of both contributions and their earnings in retirement are tax-free.

Many employers also contribute to their employees’ 401k accounts. These can be a match, where the employer contributes a certain amount based on the employee’s own contributions, such as 50 cents for every dollar the employee saves up to 6% of their salary. Other employers may make non-elective contributions, also known as profit-sharing, where they contribute to every eligible employee’s account regardless of whether the employee contributes.

An overall limit caps the total amount of contributions from all sources. For 2025, this comprehensive limit is $70,000, or $77,500 for those eligible for the standard age 50 catch-up, and $81,250 for those aged 60 to 63.

While an employee’s own contributions are always 100% their own, employer contributions are often subject to a vesting schedule. Vesting determines when the employee gains full ownership of the employer’s contributions. A plan might use three-year “cliff” vesting, where an employee becomes 100% vested after three years of service, or graded vesting, where ownership increases incrementally, for instance, by 20% each year over five years.

Withdrawal and Distribution Rules

The rules for taking money out of a 401k are designed to preserve funds for retirement. Participants can begin taking distributions without penalty once they reach age 59½. At this point, funds from a traditional 401k are treated as ordinary income for tax purposes. For Roth 401k accounts, distributions are tax-free if the account has been funded for at least five years and the participant is 59½.

Taking money out before age 59½ results in an early withdrawal penalty. The IRS imposes a 10% additional tax on the distribution, on top of the ordinary income tax owed. For example, a person in a 22% federal tax bracket who takes a $10,000 early withdrawal would owe $2,200 in income tax plus a $1,000 penalty.

Certain situations allow for penalty-free early withdrawals, including:

• Distributions made due to the account holder becoming totally and permanently disabled.
• Distributions made to a beneficiary after the participant’s death.
• Withdrawals made by an individual who separates from service with their employer during or after the year they turn 55, known as the Rule of 55.
• Payments for qualifying medical expenses exceeding a certain percentage of adjusted gross income.
• Distributions made under a Qualified Domestic Relations Order (QDRO) in a divorce.

A hardship withdrawal may be permitted if the participant has an “immediate and heavy financial need.” Even if approved, the amount is subject to ordinary income tax and the 10% early withdrawal penalty unless another exception applies. IRS-approved needs include:

• Costs for medical care.
• Expenses to purchase a principal residence.
• Tuition and related educational fees.
• Payments to prevent eviction or foreclosure.

To ensure retirement funds are used during a person’s lifetime, the IRS mandates Required Minimum Distributions (RMDs). Participants must begin taking RMDs from their traditional 401k accounts by April 1 of the year after they reach age 73. The RMD amount is calculated annually based on the account balance and life expectancy, though this rule does not apply to individuals still working for the company sponsoring the plan if they are not 5% owners.

Rules for 401k Loans

Not all 401k plans permit participants to borrow from their accounts, as this feature is at the employer’s discretion. If loans are permitted, they are governed by specific IRS rules to distinguish them from permanent withdrawals.

The amount a participant can borrow is limited to the lesser of $50,000 or 50% of their vested account balance. Any outstanding loan balance from the previous 12 months reduces the $50,000 limit. An exception allows a participant to borrow up to $10,000 even if it exceeds the 50% threshold.

Repayment must follow a structured schedule, generally within five years, though a longer period may be allowed if the funds are used to purchase a primary residence. Payments include both principal and interest and are made through automatic payroll deductions. The interest rate must be commercially reasonable, and the interest paid goes back into the participant’s own 401k account.

Failing to repay the loan according to its terms has significant consequences. A defaulted loan is treated by the IRS as a taxable distribution. This means the amount will be subject to ordinary income tax and, if the participant is under age 59½, the 10% early withdrawal penalty.

Rules When Changing or Leaving a Job

When an employee with a 401k balance separates from their employer, they have several choices for their funds:

• Leave the money in the former employer’s plan.
• Roll the funds over to a new employer’s 401k.
• Roll the funds into an Individual Retirement Account (IRA).
• Cash out the account balance.

Leaving the funds in the old plan is possible if the vested balance is above $7,000, which allows the investments to continue growing tax-deferred. If the balance is between $1,000 and $7,000, the former employer may force the funds into an IRA. For balances under $1,000, the employer might cash out the account and send the participant a check.

A rollover is the process of moving retirement funds from one qualified account to another. In a direct rollover, the administrator of the old plan sends the money directly to the new 401k or IRA, avoiding any tax consequences.

In an indirect rollover, the old plan administrator sends a check to the participant but is required to withhold 20% for federal income taxes. The participant then has 60 days to deposit the full amount of the original distribution into a new retirement account, using their own funds to make up the 20% that was withheld. If only the amount received (80%) is rolled over, the withheld 20% is treated as a taxable distribution and may be subject to the 10% early withdrawal penalty.