401(k) Plans: What Are They, How They Work

This information is provided for general informational purposes only and does not constitute investment or tax advice. Investors should consult with their own qualified financial or tax advisors before making any investment or tax-related decisions.

401(k)s are the most common type of retirement plan – but what is a 401(k) exactly and how does it work? In this guide, we explain the difference between traditional and Roth 401(k)s, how contributions, withdrawals, and employer matching work, the pros & cons of 401(k)s, and how they compare to other retirement savings plans. 

What is a 401(k) plan?

A 401(k) is a company-sponsored retirement plan that lets you save and invest a portion of your income. In most cases, you decide what percentage of your income to contribute, and your employer automatically withholds that amount from your paycheck and places it into the 401(k) account. Because the money is invested, it has the potential to grow over time, helping you build a healthy fund for retirement.

How 401(k)s work

When you sign up for a 401(k), you’re agreeing to save a percentage of your paycheck. Many employers offer to match your contributions, meaning they deposit extra money into your account based on how much you put in. This is essentially free money that’s going towards your retirement.

Your employer will offer a range of investment options, usually stock and bond mutual funds or target-date funds. Target-date funds are popular because they automatically shift your investments to become more conservative as you get closer to your retirement date, helping reduce the risk of losses later on.

Traditional 401(k)s vs. Roth 401(k)s

There are two basic types of 401(k)s depending on when you pay taxes on the money.

Traditional 401(k)s

In a traditional 401(k), you make pre-tax contributions. This means the money is taken out of your paycheck before federal income taxes are calculated, which reduces your taxable income for the year.

The benefit of a traditional 401(k) is that it provides a tax break today. But when you withdraw the money in retirement, you’ll pay ordinary income tax on both your original contributions and the investment growth.

Roth 401(k)s

Contributions to a Roth 401(k) are made with after-tax dollars, meaning you contribute your pay after income taxes have been deducted. This means you don’t get an immediate tax deduction on contributions, but your money can potentially grow tax-free.

The benefit of a Roth 401(k) is that you don’t have to pay any tax on withdrawals made in retirement (so long as you follow withdrawal rules). However, this means you take home less pay compared to a traditional plan because you’ll be paying taxes on that money now.

Choosing between pre-tax vs Roth

If you think you’re in a higher tax bracket now than you will be in retirement, a traditional 401(k) may be a better move because it’ll save you paying high taxes now.

If you expect to be in a higher tax bracket in the future, the Roth 401(k) allows you to lock in today’s lower tax rate. However, because you’ll be paying tax now, the Roth 401(k) reduces your spending power more, which may not be reasonable if you have a tight budget.

You also don’t have to pick just one type of 401(k). Many financial experts suggest diversifying your retirement tax strategy by having some money in a traditional 401(k) and some in a Roth.

401(k) plan contribution limits

The IRS sets limits on how much you and your employer can contribute to a 401(k) plan each year. These dollar limits are adjusted periodically to keep up with inflation, allowing you to save more as the cost of living increases.

Employee contribution limits

For 2026, the individual contribution limit for workers is $24,500 (IRS website, 03.17.26). This applies to the total of your traditional and Roth 401(k) contributions combined – so if you have both accounts, you can only contribute $24,500 total.

If you’re aged 50 or older, you can take advantage of catch-up contributions, which allow you to save even more. For 2026, the standard catch-up limit is $8,000. There’s also a new rule for those aged 60 to 63, allowing for a total catch-up of $11,750 instead of the standard $8,000. 

Employer contribution limits

There’s also an overall limit on total contributions (your money + your employer’s money). In 2026, this combined total cannot exceed $72,000, or 100% of your compensation, whichever is lower (IRS website, 03.17.26). If you’re 50 or older, your catch-up contributions are allowed on top of this $72,500 cap.

Employer matching

Most employers offer matching contributions to their employees’ 401(k) plans, allowing you to grow your retirement savings faster. You can think of employee contributions as being essentially a risk-free return on your money, so it’s important to take advantage of these contributions if you can.

Types of employer contributions

Employers can contribute to a 401(k) in different ways:

• Partial match: The employer matches a percentage of what you put in, up to a limit. For example, a company might match 50% of your contributions on the first 6% of your salary. So if you earn $100,000 and contribute $6,000 (6%), the company adds $3,000.
• Dollar-for-dollar match: The employer matches 100% of your contribution up to a certain limit. So if you put in $6,000, the company also puts in $6,000.
• Non-elective contributions: Some companies put money into your 401(k) regardless of whether you contribute anything yourself. These are usually calculated as a flat percentage of your pay.

401(k) vesting rules

Vesting refers to how much of the money in your account you actually ‘own’ if you were to leave your job. While the money you contribute is always 100% yours from day one, your employer’s contributions often aren’t considered ‘yours’ until you’ve remained at the job for a certain period of time.

If a company has a vesting schedule, you might not be able to keep the contributions they’ve made to your 401(k) unless you’ve stayed for the minimum required time. Some common vesting schedules include:

• Cliff vesting: You become 100% vested all at once after a specific period of time (e.g. after three years at the company). If you leave before that time, you lose all employer contributions.
• Graded vesting: Your ownership grows gradually over time. For example, you might be 20% vested after two years, 40% after three, and so on, until you reach 100%.

If you leave your job before you’re fully vested, you forfeit the unvested portion of the employer’s contributions. This money stays with the company and is removed from your account balance.

How 401(k) funds are invested

When you contribute to a 401(k), the money is invested based on the options you choose from your employer. This is usually a mix of mutual funds, index funds, exchange-traded funds (ETFs), money market funds and target-date funds, depending on your risk tolerance and time to retirement. 

For many people, the simplest way to manage their 401(k) investment is through a target-date fund. This includes a mix of stocks, bonds, and other securities that are automatically adjusted to be more conservative as you approach retirement age. You choose the fund with the year closest to when you plan to retire, and it automatically reduces risk to protect your savings.

401(k) withdrawals

A 401(k) is designed specifically for retirement. For that reason, the IRS makes it difficult (and expensive) to take your money out before reaching the age of 59½.

Early withdrawal penalties

Generally, if you withdraw funds before you reach the age of 59½, you will owe ordinary income taxes on the distribution plus a 10% early withdrawal penalty (IRS website, 03.17.26. For example, if you were to cash out $100,000, you’d have to pay $1,000 in penalties before the IRS takes its share of taxes.

For this reason, it’s important to keep an emergency fund in a high-yield savings account outside of your 401(k), so you aren’t forced to tap into your retirement fund too early.

Early withdrawal exceptions 

There are certain situations where the IRS allows you to bypass that 10% penalty, although you’ll still owe income tax. As of 2026, these exceptions include:

• You leave your job in or after the year you turn 55, in which case you can often take penalty-free withdrawals from that specific employer’s plan
• You have immediate and heavy financial needs, such as medical expenses exceeding your 7.5% of your income,
• You’re diagnosed with a terminal illness or become permanently disabled
• You sustain economic loss after a federally declared disaster, in which case you can withdraw up to $22,000
• You’re adopting a child, in which case you can withdraw up to $5,000 per child
• You’re the victim of domestic abuse and withdraw $10,000 or 50% of your account (whichever is less).

You can also make a one-time withdrawal of up to $1,000 for personal or family emergencies. Note that you may need to provide documentation to avoid paying the penalty in the above cases.

You can view a full list of exceptions on the IRS website.

401(k) loans

If you aren’t eligible to make a permanent withdrawal, you may be able to take out a loan from your 401(k) if your plan allows it. 

The benefit of doing this is over turning to a bank is that you’d be paying the interest back to yourself and there’s no credit check required. However, the money you’d borrow won’t be invested while it’s out of the account, so you’d be missing out on potential growth.

If you leave your job, you might also be required to pay the full loan back immediately. If you can’t, it’ll be treated as a distribution and trigger taxes and penalties.

Required Minimum Distributions (RMDs)

At some point, the IRS will require you to start taking money out of your tax-deferred retirement accounts. These are called Required Minimum Distributions (RMDs). Generally, you must start taking RMDs once you reach age 73^, or 75 if you were born 1960 or later (IRS website, 03.17.26).

You can calculate your RMDs by taking your 401(k) account balance as of December 31st the previous year, and dividing it by your ‘distribution period’ (a number the IRS assigns to each age). For example, let’s say you’re 75 and have $1 million saved. Your distribution period according to the IRS is 24.6, so your RMD for the year would be roughly $40,650.

If you fail to take out your full RMD, you might have to pay a penalty on the amount that should have been withdrawn. Many major financial institutions can help you calculate these numbers to make sure you’re meeting the threshold, and some will also offer automated withdrawals if your account is held with them.

What happens to your 401(k) when you leave a job?

When you change jobs, you have four options for what to do with the 401(k):

1. Leave it where it is

If your account balance is at least $5,000, most employers will let you keep the money in their plan indefinitely. This is a good option if you like the current investment choices and the fees are low, but keep in mind you will no longer be able to make new contributions to that specific account.

2. Roll it into an IRA

You can move your funds into an Individual Retirement Account (IRA) at a bank or brokerage firm. This is often the most flexible choice because it gives you access to almost any investment on the market, not just the ones your employer picked. You also won’t owe any immediate taxes so long as you follow the IRS rollover rules.

3. Move it to your new employer

If your new job has a 401(k) plan, you can usually roll your old balance into the new plan. This keeps your retirement savings in one place and makes it easier to track your progress.

4. Withdraw the cash

Cashing out is generally considered a last resort. Unless you’re 59½ or older, you’ll likely have to pay a 10% withdrawal penalty and income taxes. You’ll also lose out on all the future growth that money would have earned.

401(k)s vs. other retirement plans

Pension plan vs 401(k)

A pension is a defined benefit plan. This means your employer is responsible for funding it and guarantees you a specific monthly check for life based on your salary and years of service.

A 401(k), on the other hand, is a defined-contribution plan. This means you’re responsible for both funding it as well as choosing the investments. Your retirement payout will depend on how much you’ve saved and how the market performed, providing less predictable income compared to a pension plan.

401(k) vs IRA

The biggest differences between a 401(k) and IRA are the contribution limits and the role of the employer. In 2026, you can put up to $24,500 into a 401(k) but only $7,500 into an IRA. 401(k)s also allow for employer matching, essentially giving you free money, while IRAs don’t. 

Another difference is that IRAs offer almost unlimited flexibility when it comes to the investments you choose. With a 401(k), however, you’re limited to the options offered by your company.

Pros and cons of a 401(k)

Pros

Some of the benefits of a 401(k) plan include:

• Automation: Because the money comes out of your check before you ever see it, you’re less likely to spend it
• Employer matching: This provides a guaranteed boost to your savings
• Higher limits: You can save significantly more per year than you can in other retirement accounts
• Tax benefits: You either get a tax break now (traditional) or tax-free income later (Roth).

Cons

Some of the potential drawbacks of a 401(k) include:

• Limited access: You’ll likely have to pay a penalty if you need to access the money before age 59½
• Lack of investment flexibility: You generally have to choose from the funds your employer offers
• Management fees: Some plans come with administrative fees that can eat into returns over time, though they’re typically modest.