Understanding 401(k) Plans

A 401(k) plan is one of the fundamental vehicles for retirement savings in the United States, alongside the Individual Retirement Arrangement (IRA). 401(k) plans are named after the section of the US tax code they are based on, and are the primary method under which employees build retirement savings with contributions from their employer.

What is a 401(k)?

A 401(k) is a “defined contribution” retirement account, provided by many employers to their employees. Employees can contribute a portion of their earnings to their 401(k) account, and their employer may contribute a matching amount. These contributions are then invested (usually in stocks, funds, or bonds), growing until the employee is of retirement age, at which point they can be withdrawn.

Defined Contribution vs Defined Benefit

Above we said “Defined Contribution”. This means the employer is obligated to contribute some funds into the 401(k) account each year, which then is owned by the employee (who typically has some say in how those funds are invested). The value of the 401(k) account, and therefore how much will be available at the time of retirement, depends on how the stocks, funds, and bonds owned by the account grow over time.

This is in contrast to a “Defined Benefit” plan, or a pension. With a defined benefit plan, employers guarantee some level of monthly income for the employee after retirement for the rest of their life – usually some percentage of their final salary with the company before retirement.

Defined benefit plans are rare today, outside unionized industries (where they are frequently a major sticking point in union negotiations).

Tax Advantage

401(k) accounts are taken “pre-tax” – meaning the money you contribute to your 401(k) is taken out before any federal or state income tax. This means these contributions give you free money off-the-bat in that you did not pay any income tax on it (and will get a tax refund if you had a withholding on it) – with the flip side that you will need to pay income tax on the returns you get when you withdraw.

Roth 401(k)

There is a variation of the 401(k) offered by some employers called a Roth 401(k). The Roth version (named after the Senator who proposed similar rules for IRA accounts) has you pay the full income tax on your earnings today – but the growth on your investments can be withdrawn tax-free when you retire.

401(k) Contributions and Employer Matching

401(k) accounts are an employee benefit provided by an employer – they are a “perk” of any job for which they are offered. Employees at a company that offers a 401(k) account have the option to enroll (which is sometimes automatic – but one can always opt-out).

Employer Matching

The biggest benefit of the 401(k) account is Employer Matching – in addition to your own contribution, your employer deposits money into your account too, which is above and beyond your regular salary.

Matching vs Annual Contributions

Employers typically have two different types of contributions they make to your account – Annual and Matching.

An Annual Contribution is a one-time contribution every year, equivalent to some percentage of your base salary (typically 1-3%, although some offer none and some offer more).

A Matching Contribution is made at the same time you make your own contribution – your employer contributes a dollar for every dollar that you contribute yourself. This is also limited, usually to 2-10% of your base salary per year (depending on your company).

Employer contributions are effectively “free money” – they cost you absolutely nothing, and get added directly to your retirement account. The only “catch” is in the Matching Contribution – if you don’t contribute everything you can (up to your company’s limit), you are leaving free money on the table!

Vesting Periods

Employer contributions do have a caveat – a “Vesting Period”. This is a concept that lets employers take back any contributions they make to employee 401(k) accounts if that employee quits, designed to encourage employees to stay with the same company for a long time. If you leave before the “vesting period” is over, the company can claw back some, or all, of their matched contributions (but any amount you contributed directly is always yours).

Vesting periods vary by company, but by law they cannot extend beyond 6 years (with you “owning” 20% more each year).

Legal Limit Vesting Schedule

In the absolute legal-limit vesting schedule, if you leave after your 3^rd anniversary with the company, the company would “claw back” 60% of their matched contributions to that point. The upside is that any growth on those contributions still stay in your account – they can only take back what they originally put in. However, most employers offer less-strict schedules (with many giving 100% vesting after just 1 year, or even immediately).

Automatic Contributions

One of the key benefits of a 401(k) account is automatic contributions taken directly from your paycheck – you do not need to remember to set aside separate savings or make manual contributions to your account.

Tax Burden

The contributions you make to your 401(k) account are “pre-tax”, which means whatever you pay into your 401(k) account is subtracted from your “taxable income”. This means that for your annual budget, your 401(k) contributions will increase your tax refund – giving you extra cash you can use now, while still funding your retirement in the future!

Maximizing Contributions

You have control over the automatic contributions. Many employers will set the “default” automatic contributions to some amount lower than their “match”.

For example, your automatic contribution might only be 1% of your income, but they will match up to 5%. This means you’re leaving 4% of your base salary on the table!

The good news is that you can always adjust your automatic contribution (exactly how is different from job to job, you would need to check your employee handbook). This will let you increase your contribution up to the max matching contribution as long as you can afford to. Because 401(k) contributions are automatic, maximizing these automatic contributions makes it much easier to plan your monthly budget – retirement savings is already taken care of – so make sure you get every dollar you can out of it!

Discretionary Contributions

You can deposit more to your 401(k) than your employer will match – up to a given limit that changes each year. This is called a “discretionary contribution”, and it allows you to deposit even more to your retirement savings if you choose to (more contributions = more long-term growth!). Even if your automatic contributions were below the “employer match”, you can make up for it (and get that free matching money) through discretionary contributions.

Investments In A 401(k)

Unlike an IRA account (where you have an extremely wide range of possible investments), your investment options are usually limited in a 401(k) account. The investment options vary widely by company, but you will usually be limited to a selection of managed investments (like mutual funds or index funds). This means you cannot buy any stock, fund, crypto, or other investment you want (like you could with a regular brokerage account), but it also makes it much easier for the average person to understand what they are getting into.

Most companies’ 401(k) accounts will offer a few investment options, so you probably will not be locked into a single “plan”, and none of these will be a bad deal. Usually you will have access to several index funds (of varying risk tolerances), or even tailored funds that adjust as you get closer to retirement.

Withdrawing From Your 401(k)

There are severe tax penalties for withdrawing from your 401(k) before retirement age (as of 2026, defined as 59.5 years old). But once you are old enough, you can start withdrawing money – paying some income tax on the withdraws (since you do not pay any income tax on the contributions).

Borrowing from your 401(k)

If you really need it, most employers allow you to “borrow” from your 401(k) account. This can be up to 50% of the total value of the account (including employer contributions) or $50,000 – whichever is smaller. The “loan” has interest – but you are only borrowing from yourself, so the interest you pay on the loan is paid back into your 401(k) account – not “spent” money. Since you are only borrowing from yourself, there are no complicated credit checks or difficulty accessing the money – but your company’s custodian of the retirement accounts may need to approve the reason for the loan.

If you borrow from your 401(k), you will immediately have additional withholdings from your paycheck to pay back the loan, which is amortized (usually) over 5 years. You can always pay this back faster – and some companies might bar you from making “regular” 401(k) contributions until the loan is paid back.

Why Borrow?

Some good reasons to borrow from your 401(k) account would be to buy your first home or pay off excessive credit card debt/student loans. But it should not be treated as your “emergency fund”, since it needs to be paid back with interest, and while you are borrowing it your retirement savings is not growing.

 Rollover

A 401(k) account is fundamentally tied to your employer. This means if you change jobs, you cannot keep contributing to that account.

The good news is that the account does not go away – it will still exist (subject to account minimums, which might force you to close it and “roll over” or withdraw the value), but the bad news is that you cannot continue to make contributions in the same way.

Into Another 401(k)

If you quit your job and get another job that offers a 401(k), you will almost always have the option to “roll over” the 401(k) account from your first job into the 401(k) program of your new job. This might mean different investment options (so you will need to pick what you want again), but you will not have any tax penalty. So long as you met the Vesting Period from your first job, everything switches over with very little change.

Into an IRA

If your new job does not offer a 401(k), or if you do not immediately have a new job, you can also “roll over” your 401(k) into an IRA account. IRA accounts are typically much more flexible in investment options than a 401(k), but do not offer any employer matching options. The plus side is rolling over your 401(k) into an IRA gives you a lot more flexibility in how you want to manage your investments, and can simplify retirement planning (instead of having several open 401(k) accounts from previous employers, consolidating them into a single IRA). You can learn more about IRA accounts in our lesson on Individual Retirement Arrangements lesson.

The Last Word

If you have a job that offers a 401(k) account, you absolutely should take advantage of it – especially up to the limit of any employer matching contributions. Any less, and you are just leaving money on the table – and short-changing your future self.

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