What is a 401(k), and How Does it Work?

If you’re overwhelmed with the idea of retirement planning or unsure where to start, a 401(k) plan may help. It’s a powerful tool for retirement savings that can help finance your lifestyle once you’re out of the workforce.

Below, we’ll break down what a 401(k) is, how it works and how it can contribute to your long-term financial goals.

What is a 401(k)?

Offered by many employers, a 401(k) is an employer-sponsored retirement savings plan that enables special tax benefits for plan participants. Its name comes from “Section 401” in the U.S. Internal Revenue Code, and it allows employees to contribute a portion of their paychecks toward retirement, often with employer matching contributions. Unlike other types of savings accounts, a 401(k) is specifically designed for retirement. The money is usually invested in stocks, bonds and mutual funds.¹

How much should you contribute to your 401(k)?

How do you know how much to contribute to your 401(k)? The answer depends on how much you can afford, how much you hope to save for retirement and maximum contribution limits. At minimum, you may want to consider contributing enough to meet your employer’s match, which is essentially “free money.” The earlier you start contributing, the longer your money has to grow.

How does a 401(k) work?

If you have access to a 401(k) plan through your employer, you may choose how much you contribute to it each year. But you can’t exceed the maximum contribution limits set forth by the Internal Revenue Service (IRS), which changes on an annual basis. For 2026, the maximum is $24,500 if you’re under 50. You can contribute an additional $8,000 if you’re over 50 and an extra $11,250 if you’re between 60 and 63.²

Some 401(k) plans offer employer matching, which means when you contribute a portion of your salary, they’ll contribute the same amount. There are two types of matching: dollar-for-dollar up to a certain amount and percentage matching.

• Dollar-for-dollar: The employer contributes the same dollar amount that you contribute from each paycheck, up to a certain annual limit.
• Percentage: The employer matches your contribution up to a percentage of your salary. For example, if your employer offers a 6% match, they’ll add up to 6% of your salary to your 401(k) if you contribute that amount. If you earn $60,000 per year and put in 6% for the year ($3,600), your employer will also add $3,600 to your account. But if you put in less, they’ll only match up to the amount you contribute.

In either case, it’s important to understand that employers have different methods for contributing to employees’ 401(k) savings and that many contributions are subject to a vesting requirement. Rather than being available to you immediately, employer contributions vest over time, meaning you may have to work at the company for a certain period before those funds become yours. The money you contribute yourself is always 100% yours.

Once you decide how much you want to contribute to your 401(k), you’ll set up a paycheck deduction with your employer, typically online after a certain period of employment. You’ll also select from a list of investment options, such as mutual funds. All investments are subject to loss as well as potential gains, and the best choice for you depends on factors like your risk tolerance and how close you are to retirement. If you don’t make a specific choice, the funds are generally placed in default investments based on a target retirement date.

Every time you get paid, your traditional 401(k) contribution will be automatically deducted from your paycheck before taxes and invested based on your selections. The money grows tax-deferred, meaning you won’t pay taxes on it until you start to withdraw. If your company offers a Roth 401(k), you’ll contribute after-tax dollars, but you won’t pay taxes when you withdraw.

You can withdraw from your account when you turn 59 ½ or sooner if you qualify for a disability or hardship withdrawal.³ If you access your 401(k) funds early, you may be on the hook for a 10% early withdrawal penalty. Plus, you’ll have to add the withdrawal amount to your total income when you file your annual taxes.⁴

Types of 401(k) plans

In general, there are two types of 401(k) accounts you may be able to choose from: traditional and Roth.⁵

Traditional 401(k)

With a traditional 401(k), you make pre-tax contributions, which lowers your taxable income. You also won’t pay any taxes on the money you contribute or your investment growth until you begin to withdraw from your account in retirement. At that point, you’ll be taxed on the funds as if they’re regular income.

For a traditional 401(k), you’ll need to take the required minimum distribution (RMD). An RMD is the minimum amount of money you must withdraw from a traditional 401(k) plan after you reach a certain age. It starts the year when you turn 73, and if you don’t adhere to it, you’ll likely have to pay a penalty.

Roth 401(k)

If you opt for a Roth 401(k), you’ll make contributions to your account after you’ve already paid taxes on your income. Then your money will grow tax-free, and you won’t have to pay taxes on it when you make withdrawals in retirement. You should note that a Roth 401(k) is different from a Roth IRA, which doesn’t allow employer matches.

Unlike traditional 401(k)s, Roth 401(k)s do not have RMDs.

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Start building the retirement you want today

A 401(k) is an important step to building long-term financial security, even if retirement feels like it’s a lifetime away, and especially if retirement is just around the corner. Even small contributions now could make a huge difference to your savings. It’s never too early (or too late) to invest in your future.

Sources

1. https://www.investopedia.com/terms/1/401kplan.asp
2. https://www.irs.gov/newsroom/401k-limit-increases-to-24500-for-2026-ira-limit-increases-to-7500
3. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-disability
4. https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions
5. https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/traditional-and-roth-401k-plans