How a 401(k) Works: Contributions, Growth, and Withdrawals

How money moves in and out of a 401(k)

A 401(k) is a workplace retirement account where you and your employer both put money in, and that money grows tax-deferred until you withdraw it. You choose how much to contribute from each paycheck — your employer withholds it before taxes — and your employer may match a portion of what you contribute. The money sits in investments you select, and you pay no federal income tax on the growth until you take money out after age 59½.

The account is named after the section of the tax code that created it. Your employer sets up the plan through a provider like Fidelity, Vanguard, or Schwab, and you enroll through your company's benefits system. The provider holds the actual money and handles the investments.

Unlike a savings account, a 401(k) is meant to stay untouched until retirement. If you withdraw money before 59½, you typically owe income tax on the amount plus a 10 percent penalty — though some situations allow penalty-free withdrawals. Once you turn 73, you must begin taking withdrawals whether you need the money or not.

Key Takeaways

• You contribute pre-tax dollars from your paycheck, and your employer may match a percentage of your contribution, up to annual limits set by the IRS.
• Your contributions and investment growth are not taxed until you withdraw the money, usually after age 59½.
• You choose how your money is invested from a menu of options your employer's plan offers, typically mutual funds and target-date funds.
• Withdrawals before age 59½ usually trigger a 10 percent penalty plus income tax, but certain hardships and life events have exceptions.
• At age 73, you must begin taking required minimum distributions, and you cannot contribute new money once you leave your job.

How much you can contribute each year

The IRS sets an annual limit on how much you can put into your 401(k) from your own paycheck. For 2024, that limit is $23,500 if you are under age 50. If you are 50 or older, you can contribute an additional $7,500 in "catch-up" contributions, bringing your total to $31,000.

These limits change most years — the IRS adjusts them for inflation. Your employer's match does not count toward your personal contribution limit, but it does count toward the total plan limit, which is much higher. If you change jobs mid-year, your contributions from both employers combined cannot exceed the annual limit, or you will owe taxes and penalties on the overage.

Your paycheck deduction is taken before federal income tax is calculated, which lowers your taxable income for the year. If you earn $60,000 and contribute $10,000 to your 401(k), you pay federal income tax only on $50,000.

How your employer's match works

Many employers offer a match: they contribute money to your 401(k) based on how much you contribute. A common match is 50 percent of the first 6 percent you contribute — meaning if you contribute 6 percent of your salary, your employer adds 3 percent. The exact match formula varies by employer and is spelled out in your plan documents.

The match is information programs, but you have to contribute to receive it. If your employer offers a match and you do not contribute, you are leaving that money on the table. Some employers require you to work there for a certain period before the match is fully yours — this is called vesting. If you leave before you are fully vested, you forfeit the unvested portion of the match.

Your employer's match is not taxed to you when it goes in, and it grows tax-deferred like your own contributions. When you withdraw it in retirement, you pay income tax on it then.

How investment choices and growth work

Once money is in your 401(k), you direct how it is invested. Your employer's plan offers a menu of investment options — usually mutual funds, index funds, and target-date funds. You can split your contributions among these options however you want, and you can change your allocation at any time.

A target-date fund is designed for people retiring in a specific year — for example, a "2050 Target Date Fund" is built for someone who plans to retire around 2050. These funds automatically shift from stocks to bonds as your target date approaches, becoming more conservative over time. Many people choose a single target-date fund that matches their expected retirement year and do not change it.

Your money grows through investment returns — dividends, interest, and capital gains. You pay no federal income tax on this growth while the money is in the account. If a fund earns 7 percent one year, that full 7 percent stays in your account and compounds the next year. This tax deferral is one of the main advantages of a 401(k).

When you can withdraw money and what it costs

You can withdraw money from your 401(k) at any time, but the tax and penalty consequences depend on your age and reason. If you withdraw before age 59½, you owe federal income tax on the amount plus a 10 percent early withdrawal penalty. On a $10,000 withdrawal at age 45, you might owe $2,200 in taxes and penalties combined, depending on your tax bracket.

Some situations allow you to withdraw money before 59½ without the 10 percent penalty, though you still owe income tax. These include a permanent and total disability, medical expenses that exceed 7.5 percent of your adjusted gross income, and substantially equal periodic payments (a complex calculation). A few plans allow loans against your 401(k) balance, which you repay with interest — this avoids the penalty but ties up your retirement money.

If you leave your job, you can leave your money in the old employer's plan if the balance is over $5,000, move it to your new employer's plan if that plan accepts transfers, or roll it into an Individual Retirement Account (IRA). A rollover to an IRA does not trigger taxes or penalties if done correctly — the money moves directly from one institution to the other.

Required withdrawals and what happens at retirement

Once you turn 73, you must begin taking required minimum distributions (RMDs) from your 401(k) each year, whether you need the money or not. The IRS calculates the minimum based on your age and account balance. If you do not take the full amount, you owe a 25 percent penalty on the shortfall (reduced to 10 percent if you correct it within two years).

If you are still working at age 73 and do not own more than 5 percent of the company, some plans allow you to delay RMDs until you actually retire. This is called the "still-working exception." Check your plan documents or ask your benefits administrator whether your plan offers this.

When you retire, you decide how to access your money. You can take lump-sum withdrawals whenever you want (paying income tax on each withdrawal), set up regular monthly withdrawals, or leave the money invested and withdraw only what you need. Some people roll their 401(k) into an IRA for more investment choices and lower fees.

How a 401(k) differs from other retirement accounts

A 401(k) is an employer-sponsored plan, which means your employer sets it up and chooses the provider and investment options. An Individual Retirement Account (IRA) is opened by you alone and offers more investment choices, but contribution limits are lower — $7,000 per year for 2024 if you are under 50. An IRA has no employer match.

A Roth 401(k) is offered by some employers as an alternative or addition to a traditional 401(k). You contribute after-tax dollars (no when ready tax deduction), but withdrawals in retirement are tax-free. The contribution limits are the same as a traditional 401(k), and employer matches go into a traditional account even if you choose Roth contributions.

A SEP IRA or Solo 401(k) is for self-employed people and small business owners. These allow higher contribution limits than a regular IRA but require more paperwork. If you leave your job, you cannot contribute to that employer's 401(k) anymore, but you can open an IRA or continue contributing to a Solo 401(k) if you have self-employment income.

Frequently Asked Questions

What happens to my 401(k) if I leave my job?

You keep the money — it is yours. You can leave it in your old employer's plan if the balance exceeds $5,000, roll it into your new employer's plan, or roll it into an IRA. If you withdraw it as a check, you have 60 days to deposit it into another retirement account or you owe income tax and a 10 percent penalty on the full amount.

Can I borrow from my 401(k)?

Some plans allow loans, but not all. If yours does, you can typically borrow up to 50 percent of your balance or $50,000, whichever is less. You repay the loan with interest, usually over five years. If you leave your job before repaying, the loan balance is treated as a withdrawal and you owe taxes and penalties on it.

Do I have to invest in stocks?

No. Most plans offer bond funds, money market funds, and stable value funds alongside stock funds. A target-date fund automatically mixes stocks and bonds based on your retirement timeline. You can choose any combination of the options your plan offers, or put everything in the most conservative option available.

What if my employer does not offer a 401(k)?

You can open an Individual Retirement Account (IRA) on your own through a bank, brokerage, or investment company. Contribution limits are lower than a 401(k), and there is no employer match, but you have full control over investment choices and can open one when ready without waiting for an employer plan.

Can I contribute to both a 401(k) and an IRA?

Yes, but your IRA contributions may not be tax-deductible if you earn above certain income limits and have access to a 401(k). For 2024, if you are single and earn over $77,000, your IRA contributions begin to lose their tax deduction. The limits are higher if you are married or do not have a 401(k) available.