Your Most Common 401k Questions Answered

A 401k is an employer-sponsored retirement savings account with tax advantages. It allows employees to invest a portion of their earnings for long-term growth. As a defined contribution plan, the final payout is determined by the amount contributed and the performance of the investments.

The Internal Revenue Code governs the rules for contributions, investments, and withdrawals. Because they offer a simple way to save directly from a paycheck, 401k plans are a common part of employee benefits packages.

Making Contributions to Your 401k

Employee Contributions

The foundation of a 401k is the employee’s contributions, made through salary deferrals. For 2025, the IRS allows employees to contribute up to $23,500 from their salary. This limit applies to the total an employee contributes across all their 401k plans.

The tax code includes provisions for “catch-up” contributions for individuals age 50 and over, who can contribute an additional $7,500 in 2025. A newer provision allows those aged 60 through 63 to make a larger catch-up contribution of up to $11,250, if their plan allows it. Starting in 2026, catch-up contributions for high earners must be made on a Roth (after-tax) basis.

Employer Contributions

Many employers contribute to their employees’ 401k accounts. The most common form is the employer match, such as a company matching 50% of employee contributions up to the first 6% of their salary. Another formula is a dollar-for-dollar match on the first 3% of an employee’s contribution, and then 50 cents on the dollar for the next 2%.

Employers might also make non-elective contributions, or profit-sharing, to all eligible employees’ accounts, regardless of whether the employee contributes. The total that can be contributed from all sources is capped by the IRS. For 2025, this limit is $70,000, or higher for those eligible for catch-up contributions.

Traditional vs. Roth 401k Contributions

Employees may have a choice between a Traditional 401k and a Roth 401k. The difference is the tax treatment. Traditional 401k contributions are pre-tax, meaning the amount is deducted from gross income. This lowers current taxable income, providing an immediate tax benefit.

Conversely, Roth 401k contributions are made with after-tax dollars. While this provides no immediate tax deduction, qualified distributions from a Roth 401k, including contributions and earnings, are completely tax-free. A distribution is qualified if the account has been open for at least five years and the holder is at least 59½ years old.

The choice depends on an individual’s current and expected future tax bracket. An employee who anticipates being in a higher tax bracket during retirement may prefer the Roth option. Someone who needs to lower their taxable income now might find the Traditional 401k more advantageous.

Managing Your 401k Investments and Fees

Investment Options

Money in a 401k must be invested to grow. Plans offer a menu of investment options for different risk tolerances. Target-date funds are a simple, all-in-one solution holding a mix of stocks and bonds that automatically becomes more conservative as the target retirement date approaches.

For a more hands-on approach, plans offer index funds and actively managed mutual funds. Index funds are passively managed to replicate a market index, like the S&P 500, and have lower operating costs. Actively managed funds are run by portfolio managers who attempt to outperform the market, which results in higher fees.

Vesting Schedules

An employee’s own contributions are always 100% theirs, but employer contributions are subject to a vesting schedule. Vesting is a waiting period an employee must fulfill to gain full ownership of the employer’s portion of their account.

There are two primary types of vesting schedules: cliff and graded. Under a three-year cliff vesting, an employee owns 100% of employer contributions after three years of service but 0% before that. A common six-year graded schedule gives an employee 20% ownership after two years, with an additional 20% gained each year until they are fully vested after six years.

Understanding 401k Fees

Operating a 401k involves costs passed on to participants as fees, which reduce long-term returns. Fees fall into three categories. The first is plan administration fees, which cover record-keeping and accounting and can be a flat amount or a percentage of assets.

The second and largest category is investment fees, expressed as an expense ratio. An expense ratio of 0.50% means a participant pays $5 for every $1,000 invested in that fund each year. The average expense ratio for equity mutual funds in 401k plans was 0.31% in 2023.

Finally, individual service fees are charged for specific actions, like processing a loan. Fee information is disclosed in plan documents and on account statements. Even small differences in fees can have a substantial impact over several decades of saving.

Accessing Your 401k Before Retirement

Options When Changing Jobs

When an employee leaves a job, they must decide what to do with their 401k. The four main options are:

• Leave the money in the old employer’s plan, which is possible if the vested balance is over $7,000. You will no longer be able to make contributions to this account.
• Roll the funds over into an Individual Retirement Account (IRA). This provides a wider range of investment options. A direct rollover, from the old plan to the new IRA, avoids tax consequences.
• Roll the funds into a new employer’s 401k plan, if the new plan accepts rollovers. This keeps all retirement savings consolidated in one employer-sponsored plan.
• Cash out the account. This is the least advisable choice, as the withdrawal is treated as taxable income and will face an additional 10% early withdrawal penalty if under age 59½.

401k Loans

Many 401k plans allow participants to borrow from their account balance. The participant is borrowing their own savings and paying it back to their account with interest. This can be a way to access funds without the taxes and penalties of a withdrawal.

The IRS allows a participant to borrow up to 50% of their vested account balance, with a maximum loan of $50,000. For example, someone with a vested balance of $80,000 could borrow up to $40,000. The repayment period is five years, with payments made through payroll deductions, though a longer term may be allowed for a home purchase.

If a participant leaves their job, the plan may require the outstanding loan balance to be repaid by their tax filing deadline for that year. If the loan is not repaid, the balance is treated as a taxable distribution and is subject to income tax and the 10% early withdrawal penalty if the participant is under 59½.

Hardship Withdrawals

In a situation of significant financial distress, a plan may permit a hardship withdrawal, which is a permanent distribution that is not paid back. The IRS requires an “immediate and heavy financial need,” and the withdrawal is limited to the amount necessary to satisfy that need.

Safe harbor reasons that qualify for a hardship withdrawal include:

• Certain medical care expenses.
• Costs related to the purchase of a principal residence.
• Payments to prevent eviction or foreclosure.
• Certain educational fees.
• Funeral expenses.
• Expenses for repairing damage to a principal residence or costs incurred due to a federally declared disaster.

A hardship withdrawal is included in gross income for the year and is subject to ordinary income tax. If the participant is under age 59½, the withdrawal is also subject to the 10% early withdrawal penalty.

Taking Distributions in Retirement

Rules for Withdrawals

The rules for 401k withdrawals change at retirement age. The IRS established age 59½ as the point when individuals can begin taking distributions from their 401k without the 10% early withdrawal penalty. This penalty-free access applies even if the individual is still working.

Some plans have a “Rule of 55,” which allows an employee who leaves their job in the year they turn 55 or later to take penalty-free withdrawals from that specific employer’s 401k. This exception applies only to the 401k of the most recent employer and does not extend to IRAs or 401k plans from previous jobs.

Tax Treatment of Distributions

The tax treatment of retirement distributions depends on whether contributions were pre-tax or after-tax. For a Traditional 401k, where contributions were pre-tax, all distributions are taxed as ordinary income. For a Roth 401k, where contributions were after-tax, qualified distributions are completely tax-free.

Required Minimum Distributions (RMDs)

The tax-deferred growth of a Traditional 401k cannot continue indefinitely. The IRS mandates that account holders begin taking Required Minimum Distributions (RMDs) annually. For individuals born between 1951 and 1959, the starting age is 73; for those born in 1960 or later, it is 75. RMDs are no longer required from Roth 401k accounts during the original owner’s lifetime.

The RMD amount is calculated by dividing the account balance from the end of the previous year by an IRS life expectancy factor. The first RMD must be taken by April 1 of the year after reaching the required age, and subsequent RMDs by December 31 each year. Failing to take the full RMD results in a 25% penalty on the amount that should have been withdrawn, which can be reduced to 10% if corrected promptly.