How a 401(k) Works: From Paycheck to Retirement

What happens to your money when you contribute to a 401(k)

A 401(k) is a retirement savings account that your employer offers. Money comes directly out of your paycheck before taxes are taken out, goes into an account with your name on it, and you choose how to invest it. Your employer may add money to your account too — this is called a match. The account grows over time, and you cannot withdraw the money without penalty until you reach age 59½.

The money is yours. If you leave the job, the account stays with you. You can move it to a new employer's plan, roll it into an individual retirement account (IRA), or leave it where it is. The account is separate from your paycheck and separate from your employer's money — it belongs to you alone.

Key Takeaways

• You choose how much to contribute from each paycheck, up to a yearly limit set by the IRS, and your employer deducts it before calculating your taxes.
• Your employer may match part of what you contribute — for example, 50 cents for every dollar you put in — but only if you contribute first.
• You decide how to invest the money by picking from a menu of funds your employer's plan offers, and the account grows based on how those investments perform.
• You own the account and can take it with you if you change jobs, but withdrawing before age 59½ usually costs you a 10 percent penalty plus income taxes.
• The money you contribute reduces your taxable income for the year, which lowers the income tax you owe.

How much you can contribute and when

You decide what percentage of your paycheck goes into the 401(k), and your employer deducts it automatically. The IRS sets a yearly limit on how much you can put in. This limit changes most years. For 2024, the limit is $23,500 for people under 50. If you are 50 or older, you can contribute an additional $7,500 in what is called a catch-up contribution, for a total of $31,000.

You can change your contribution amount whenever your employer allows — often once a year during open enrollment, or sometimes whenever you want. If you contribute too much in a year, your employer will catch it and return the overage to you. You do not have to contribute every year; you can pause contributions and restart them later.

Employer matching and how to get it

Many employers offer to match part of what you contribute. A common match is 50 percent of the first 6 percent you contribute — meaning if you put in 6 percent of your salary, your employer adds 3 percent. Some employers match dollar-for-dollar up to a certain percentage. Others do not offer a match at all.

The match only happens if you contribute first. If you contribute nothing, your employer contributes nothing. The match is information programs, so most financial advisors suggest contributing at least enough to get the full match your employer offers. If your employer matches 50 percent of the first 6 percent, you should contribute at least 6 percent to capture the full 3 percent match.

The match money is also yours. It goes into your account and grows along with your contributions. When you leave the job, you take the match with you.

How your money is invested

Your 401(k) plan offers a menu of investment options — usually mutual funds, index funds, and sometimes company stock. You pick how to split your money among these options. If you do not pick, your plan may automatically put your money into a target-date fund, which adjusts its mix of investments as you get closer to retirement.

The value of your account changes based on how the investments perform. If the stock market goes up, your account may go up. If the market goes down, your account may go down. You can change how your money is invested whenever you want, usually through your employer's website or app.

Most plans offer educational materials about each investment option, including how risky it is and how it has performed in the past. Past performance does not predict future results, but it can help you understand what you are choosing.

Taxes now versus taxes later

The money you contribute to a traditional 401(k) is taken out before income taxes are calculated. This means your taxable income for the year is lower, so you owe less in federal income tax. You pay taxes on the money when you withdraw it in retirement.

Some employers offer a Roth 401(k) option instead. With a Roth, you contribute money that has already been taxed, so your paycheck is smaller. But when you withdraw the money in retirement, you owe no taxes on it. Which option makes sense depends on whether you think your tax rate will be higher or lower in retirement — something nobody can know for certain.

Many plans let you do both: contribute some money to a traditional 401(k) and some to a Roth 401(k) in the same year, as long as your total does not exceed the yearly limit.

What happens when you leave your job

Your 401(k) account stays yours when you leave. You have several choices: leave it with your former employer's plan, move it to your new employer's plan if they offer one, or roll it into an individual retirement account (IRA) at a bank or brokerage firm.

Rolling the money into an IRA often gives you more investment choices and lower fees than keeping it in your old employer's plan. If you roll it into a traditional IRA, the money stays tax-deferred. If you roll it into a Roth IRA, you owe taxes on the amount you convert, but future withdrawals are tax-free.

Do not cash out the account. If you withdraw the money before age 59½, you owe a 10 percent penalty plus income taxes on the full amount. A $50,000 withdrawal could cost you $15,000 or more in taxes and penalties.

Withdrawals and penalties

You can withdraw money from your 401(k) starting at age 59½ without a penalty. Before that age, you owe a 10 percent penalty plus income taxes. Some plans allow loans against your balance, which you repay to yourself with interest — this avoids the penalty but ties up your retirement savings.

A few situations let you withdraw early without the 10 percent penalty: if you become disabled, if you are facing serious financial hardship (defined narrowly by the IRS), or if you separate from your employer in the year you turn 55 or later. You still owe income taxes on the withdrawal, but not the penalty. The rules are strict, and your plan administrator can tell you whether your situation qualifies.

Starting at age 73, you must begin taking withdrawals from your traditional 401(k) each year — these are called required minimum distributions. The amount is calculated based on your age and account balance. Roth 401(k)s have the same requirement, though Roth IRAs do not.

Frequently Asked Questions

What is the difference between a 401(k) and an IRA?

A 401(k) is offered by your employer and lets you contribute more money per year. An IRA is an account you open on your own at a bank or brokerage. IRAs have lower yearly contribution limits but often offer more investment choices. You can have both at the same time.

Can I borrow from my 401(k)?

Many plans allow loans against your balance. You repay the loan to yourself with interest, so you avoid the early withdrawal penalty. But the money is not growing while you are paying it back, and if you leave your job before repaying it, the loan is treated as a withdrawal and you owe taxes and penalties.

What happens to my 401(k) if I die?

The money goes to whoever you named as your beneficiary when you opened the account. If you did not name a beneficiary, it goes to your estate and may go through probate. You can change your beneficiary anytime, and it is worth checking that the person you named is still who you want.

Do I have to contribute to my employer's 401(k)?

No. Contributing is optional. But if your employer offers a match and you do not contribute, you are turning down information programs. Even a small contribution — enough to capture the full match — is usually worth doing.

Can I contribute to a 401(k) and an IRA in the same year?

Yes. You can contribute to both a 401(k) and a traditional or Roth IRA in the same year. However, if you have a traditional IRA and a high income, contributing to a Roth IRA may be limited. Your plan administrator or a tax preparer can tell you what applies to your situation.