What Is a Traditional 401k and How Does It Work?

A traditional 401k is an employer-sponsored retirement savings plan designed to provide a tax-advantaged way for workers to save for the future. Employees contribute a portion of their salary before taxes are calculated, which lowers their current income tax burden. The funds within the account can then grow shielded from annual taxation on investment gains. This process is made consistent through automatic payroll deductions.

Funding Your Traditional 401k

Funding a traditional 401k begins with an employee electing to defer compensation through automatic payroll deductions. Because these are pre-tax contributions, they reduce an employee’s current taxable income. For instance, an employee earning $60,000 annually who contributes 5%, or $3,000, to their 401k will only be taxed on $57,000 of income for that year.

The IRS sets annual contribution limits. For 2025, an employee can contribute up to $23,500. Individuals aged 50 and over can make additional “catch-up” contributions of $7,500, and a provision in the SECURE 2.0 Act allows a higher catch-up of $11,250 for those aged 60 to 63.

Many employers contribute to an employee’s 401k through a matching program. A common formula is for the employer to contribute 50 cents for every dollar an employee saves, up to 6% of their salary. Some employers may also make profit-sharing contributions, which are discretionary amounts given to all eligible employees.

Employer contributions are subject to a vesting schedule, which determines when an employee gains full ownership of that money. A “cliff” schedule requires a set period of service for 100% ownership, while a “graded” schedule grants ownership incrementally over time. An employee’s own contributions are always 100% vested immediately.

Managing Your 401k Investments

Once funds are deposited into a traditional 401k, they benefit from tax-deferred growth. This means that any earnings from dividends, interest, or capital gains generated by the investments are not subject to annual income taxes. The money is allowed to compound over time without being reduced by tax payments, a feature that distinguishes it from a standard taxable brokerage account. Taxes are only due when the funds are eventually withdrawn.

Participants direct how their contributions are invested from a menu of options provided by the plan administrator. These menus include a range of mutual funds with different objectives and risk levels. Common options are target-date funds, which automatically adjust their asset allocation to become more conservative as the participant approaches retirement. Other choices include low-cost index funds that track a market benchmark, like the S&P 500, and actively managed funds where a manager makes decisions aiming to outperform an index.

Accessing Your 401k Funds

Qualified distributions can begin once a participant reaches age 59½. Withdrawals taken at this age or later are taxed as ordinary income, based on the individual’s tax bracket in the year of the distribution. This includes both the original contributions and all accumulated investment earnings.

Withdrawing money before age 59½ results in a 10% early withdrawal penalty on top of the ordinary income tax owed. There are several exceptions to this penalty, such as in cases of total and permanent disability, certain unreimbursed medical expenses, or distributions to a beneficiary after death. The SECURE 2.0 Act also introduced penalty-free withdrawals for victims of domestic abuse or those with a terminal illness.

Many plans permit participants to take a loan against their 401k balance. IRS rules allow borrowing up to 50% of the vested account balance, with a maximum loan of $50,000. These loans must be repaid with interest over a period of five years. If an employee leaves their job with an outstanding loan, they must repay the balance by the tax filing deadline for that year to avoid having it treated as a taxable distribution.

Retirees must begin taking Required Minimum Distributions (RMDs). The starting age for RMDs is 73, and it will increase to 75 for those who turn 74 after December 31, 2032. The first RMD must be taken by April 1 of the year after turning the required age. Failing to take a timely RMD can result in a 25% penalty on the required amount, which is reduced to 10% if the failure is corrected promptly.

Handling Your 401k When Changing Jobs

When an employee leaves a job, they have several options for managing the funds in their 401k account:

• Leave the money in the former employer’s plan. This is an option if the plan allows it and the account balance meets a certain minimum. While this maintains the account’s tax-advantaged status, no further contributions can be made.
• Roll the funds into a new employer’s 401k plan. If the new plan accepts rollovers, this action consolidates retirement savings into a single account for simpler management. A direct rollover from one plan to another avoids tax consequences.
• Roll the 401k balance into a Traditional Individual Retirement Arrangement (IRA). A rollover to an IRA often provides a much wider range of investment options than a 401k, including individual stocks and bonds, while preserving the tax-deferred status.
• Cash out the account. The plan administrator is required by the IRS to withhold a mandatory 20% for federal income taxes. The withdrawn amount is also subject to state income taxes, and if the individual is under age 59½, the 10% early withdrawal penalty will apply.