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

A 401(k) is a workplace retirement savings account where you and your employer set aside money before taxes

A 401(k) is a retirement savings plan offered by your employer. You choose how much to contribute from each paycheck — that money goes into an account in your name, grows over time through investments you select, and you can withdraw it after you reach a certain age or leave your job. Your employer may also contribute money to your account, which is often called a match.

The account is named after a section of the tax code. It exists only if your employer offers one; there is no way to open a 401(k) on your own. If your employer does not offer a plan, you can save for retirement through other accounts like an IRA.

The main appeal of a 401(k) is the tax treatment: money you contribute reduces your taxable income in the year you contribute it, so you pay less income tax now. You pay taxes on the money when you withdraw it in retirement, presumably when your income and tax rate are lower.

Key Takeaways

• You contribute money from your paycheck before income tax is taken out, which lowers your taxable income for that year.
• Your employer may match a portion of your contribution — for example, 50 cents for every dollar you contribute up to 6 percent of your salary — which is when ready additional savings.
• You choose how to invest the money from a menu of options your employer's plan provides, usually mutual funds and target-date funds.
• You cannot withdraw the money before age 59½ without penalty in most cases, though some plans allow loans or hardship withdrawals.
• When you leave your job, you can roll the money into an IRA or another employer's 401(k) to keep it growing tax-deferred.

How much you can contribute each year

The IRS sets an annual limit on how much you can contribute to a 401(k) from your own paycheck. This limit changes most years. For 2024, the limit is $23,500 if you are under age 50. If you are 50 or older, you can contribute an additional $7,500 as a catch-up contribution, bringing your total to $31,000.

Your employer's match does not count toward your personal contribution limit — it is separate. If your employer contributes $5,000 and you contribute $23,500, the total in your account that year is $28,500, but only your $23,500 counts against the IRS limit.

You cannot contribute more than you earn in a year. If you make $20,000, you cannot contribute $23,500 even though the IRS allows it. Your payroll department will stop contributions once you reach your salary limit.

Employer matching and vesting

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 of your salary — meaning if you contribute 6 percent of your pay, your employer adds 3 percent. Some employers match dollar-for-dollar up to a certain percentage, and some do not match at all.

The match is not always yours to keep when ready. Many plans have a vesting schedule, which means you own a percentage of the employer's contribution based on how long you have worked there. A common schedule is 20 percent per year — after five years, you own 100 percent. If you leave your job after two years, you might own only 40 percent of the employer's contributions; the rest stays with the employer.

Your own contributions are always 100 percent vested when ready — the money you put in is yours from day one, regardless of how long you stay.

How the money grows and how you invest it

The money in your 401(k) does not sit in cash. You choose investments from a menu your employer's plan provides. Most plans offer mutual funds — baskets of stocks, bonds, or both — and target-date funds, which automatically shift from stocks to bonds as you approach retirement.

You can usually change your investment choices once per quarter or whenever you want, depending on your plan. If you do not choose, some plans put your money into a default investment, often a target-date fund based on your age.

The growth in your account — the gains from your investments — is not taxed each year. You only pay taxes when you withdraw the money. This tax deferral is one reason 401(k)s are powerful for long-term saving: your money compounds without being reduced by annual taxes.

When you can withdraw money and what happens if you withdraw early

You can withdraw money from your 401(k) without penalty once you reach age 59½. You will owe income tax on the withdrawal, but no additional penalty. If you withdraw before 59½, you usually owe a 10 percent penalty on top of income tax, unless an exception applies.

Common exceptions to the early withdrawal penalty include disability, a series of substantially equal payments (a specific calculation), and in some cases, a hardship withdrawal. Hardship withdrawals are allowed for things like medical bills, home purchase, or education costs, but your plan does not have to offer them, and you must prove the hardship. Even with an exception, you still owe income tax on the money.

Some plans allow loans: you borrow from your own 401(k) and repay yourself with interest. The loan does not count as a withdrawal, so there is no tax or penalty. However, if you leave your job, the loan usually must be repaid within 60 days or it becomes a taxable withdrawal.

What happens to your 401(k) when you change jobs

When you leave your job, your 401(k) stays in your name — your employer does not take it back. You have several choices: leave it with your former employer's plan, roll it into your new employer's 401(k) if they offer one, or roll it into an IRA.

A rollover moves money from one retirement account to another without triggering taxes or penalties, as long as you follow the rules. If you do a direct rollover, the money moves from one institution to another without passing through your hands. If you do an indirect rollover, you receive a check and have 60 days to deposit it into another account; if you miss the important date, it becomes a taxable withdrawal.

Rolling over to an IRA gives you more investment choices than most 401(k) plans, but rolling into a new employer's 401(k) keeps your accounts consolidated and may preserve certain protections. There is no single right choice — it depends on your situation and the plans available to you.

Required minimum distributions in retirement

Once you reach age 73, the IRS requires you to withdraw a minimum amount from your 401(k) each year, called a required minimum distribution or RMD. The amount is calculated based on your age and account balance. If you do not take the RMD, you owe a penalty on the amount you should have withdrawn.

You can withdraw more than the minimum whenever you want. If you are still working and your employer's plan allows it, you may be able to delay RMDs until you actually retire. Some people use RMDs to fund their living expenses in retirement; others use them to fund charitable donations or other goals.

Frequently Asked Questions

Can I have a 401(k) and an IRA at the same time?

Yes. You can contribute to both in the same year. However, if you have a 401(k) at work and also contribute to a traditional IRA, your IRA contribution may not be tax-deductible depending on your income. A Roth IRA has no income limits for contribution, so that is often a better pairing with a 401(k).

What happens to my 401(k) if the company goes out of business?

Your 401(k) is held by a separate financial institution, not by your employer, so it is protected even if the company fails. The employer cannot access it or use it for business purposes. You keep the money and can roll it to another account.

Can I borrow from my 401(k) to buy a house?

Many plans allow loans for any reason, including a home purchase. You borrow from your own account and repay with interest. However, if you leave your job before repaying, the loan becomes a taxable withdrawal. Consult your plan documents to see if loans are offered and what the terms are.

Is a 401(k) the same as a pension?

No. A pension is funded and managed entirely by your employer, and they pay you a set amount each month in retirement. A 401(k) is funded by you and your employer, you manage the investments, and the amount you receive depends on how much you saved and how well your investments performed.

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

You can open a traditional or Roth IRA on your own through a bank, brokerage, or other financial institution. An IRA has lower annual contribution limits than a 401(k), but gives you full control over investments and no employer involvement is needed.