What Is a 401k and How Does It Work?

A 401(k) plan, named after the section of the tax code that established it, is a retirement savings vehicle offered by employers that allows workers to invest a portion of their paycheck. When an employee enrolls, they agree to have a percentage of their salary automatically deducted and deposited into the account. The money is then invested according to the employee’s choices from a menu of options.

The funds within a 401(k) grow on a tax-advantaged basis. Depending on the type of contributions, taxes are either deferred until retirement or paid upfront. This structure allows investment earnings to accumulate without being taxed annually, helping savings compound more effectively.

Contribution Rules and Types

Employee contributions are subject to annual limits set by the Internal Revenue Service (IRS). For 2025, the maximum amount an employee under age 50 can contribute is $23,500. This limit applies to the total of all employee contributions to both Traditional and Roth 401(k)s.

The IRS allows for catch-up contributions for those closer to retirement. Employees aged 50 and over can contribute an additional $7,500 for 2025, for a total of $31,000. A provision in the SECURE 2.0 Act also allows a higher catch-up amount of $11,250 for those aged 60 to 63, if the plan permits it.

Many employers contribute to their employees’ 401(k) accounts as a workplace benefit. The most common form is an employer match, where the company contributes a certain amount based on how much the employee saves. A frequent formula is a dollar-for-dollar match on the first 3% of an employee’s salary and a 50-cent-on-the-dollar match for the next 2%. Some employers offer non-elective contributions, also known as profit-sharing, where they contribute to all eligible employees’ accounts regardless of employee contributions.

Employer contributions are often subject to a vesting schedule, which determines when the employee has full ownership of those funds. Under a three-year cliff vesting schedule, an employee is 100% vested after three years of service. A graded vesting schedule allows an employee to gain ownership incrementally; a common example is a two-to-six-year schedule where vesting increases by 20% each year. Employee contributions are always 100% vested immediately.

Employees have a choice between two types of contributions: Traditional and Roth. Traditional 401(k) contributions are made pre-tax, which deducts the amount from gross income and lowers current taxable income. Taxes on contributions and earnings are deferred until the money is withdrawn in retirement. In contrast, Roth 401(k) contributions are made with after-tax dollars, so there is no upfront tax deduction. The benefit is that qualified withdrawals in retirement are tax-free, provided the account has been open for at least five years and the owner is at least 59 ½.

Managing Your 401k Investments

Contributions are invested from a menu of options, with the most common being mutual funds. These funds pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. This diversification helps manage risk, as the performance of the overall portfolio is not tied to a single security.

Target-Date Funds (TDFs) are a prevalent option designed to simplify investing. A TDF automatically adjusts its investment mix over time based on a retirement date. When the date is far off, a TDF holds more aggressive assets like stocks, and as the date nears, it shifts to more conservative assets like bonds to preserve capital.

Index funds are another choice, designed to track a market index like the S&P 500. Instead of trying to outperform the market, these funds aim to mirror its returns. Because they are passively managed, index funds have lower operating expenses than actively managed funds. Bond funds, which invest in government and corporate debt, are also standard offerings that provide stability.

Asset allocation is the mix of investments within a 401(k). This balance between aggressive assets like stocks and conservative assets like bonds is used to manage investment risk. A guideline for determining stock allocation is to subtract one’s age from 110 or 120; a 30-year-old might allocate 80% to 90% to stocks. This allocation shifts toward bonds as an individual ages to reduce volatility.

Account holders should periodically review their portfolio to ensure it aligns with their goals, a process known as rebalancing. Rebalancing involves selling investments that have become an oversized portion of the portfolio and buying more of those that are underrepresented. For instance, if a target of 70% stocks and 30% bonds shifts to 80% stocks, rebalancing would involve selling stocks and buying bonds to return to the original mix. This can be done on a set schedule, such as annually.

Accessing Your 401k Funds

Many 401(k) plans allow borrowing from the account balance. IRS rules permit loans up to 50% of the vested balance, with a maximum of $50,000. For example, an employee with a vested balance of $80,000 could borrow up to $40,000. These loans must be repaid with interest over a period of five years through payroll deductions, though the period may be extended if the loan is for a primary residence.

A risk with 401(k) loans occurs if the employee leaves their job, as most plans require the balance to be repaid shortly after termination. Failure to repay the loan results in the outstanding balance being treated as a taxable distribution. This means it will be subject to income tax and, if the individual is under age 59 ½, a 10% early withdrawal penalty.

A plan may permit a hardship withdrawal for an “immediate and heavy financial need.” The IRS defines qualifying circumstances, such as certain medical expenses, costs to purchase a principal residence, tuition payments, and payments to prevent eviction. The amount withdrawn cannot exceed what is needed. A hardship withdrawal is not repaid and is subject to income tax and the 10% early withdrawal penalty.

After reaching age 59 ½, participants can take distributions without the 10% early withdrawal penalty. Withdrawals from Traditional 401(k)s are taxed as ordinary income. For Roth 401(k)s, qualified distributions are tax-free.

The IRS mandates Required Minimum Distributions (RMDs) to ensure funds are eventually used. These mandatory annual withdrawals must begin by April 1 of the year after an individual turns 73. Failing to take the full RMD results in a 25% penalty on the amount that should have been withdrawn.

Handling Your 401k When Changing Jobs

When leaving an employer, you have several options for your 401(k) funds. One choice is to leave the funds in the former employer’s plan, especially if you are satisfied with its investment choices and fees. However, if your vested balance is between $1,000 and $7,000, your former employer may move your money into an IRA if you do not provide instructions.

You can roll the funds into a new employer’s 401(k) plan if it accepts rollovers. This allows you to consolidate your retirement savings in one account, which can simplify management and tracking of your investments. The process is initiated by contacting the old plan administrator and requesting a direct rollover to the new plan.

You can also roll your 401(k) into an Individual Retirement Account (IRA). An IRA provides a wider range of investment options than a 401(k), including individual stocks and a larger selection of funds. This is best done through a direct rollover, where funds are transferred directly from the 401(k) provider to the IRA custodian to avoid tax consequences.

An alternative is an indirect rollover, where you receive a check for the balance. This method has drawbacks, as the plan must withhold 20% for federal taxes. You then have 60 days to deposit the full original amount into a new retirement account. If you fail to deposit the full amount, the shortfall is considered a taxable distribution and may be subject to a 10% early withdrawal penalty.

The final option is to cash out the account. This provides immediate access to the money but comes with tax consequences. The distribution is subject to a mandatory 20% federal tax withholding, and the entire amount is taxed as ordinary income. If you are under age 59 ½, you will also face an additional 10% early withdrawal penalty.