What a 401(k) plan is and why it matters

A 401(k) plan is a retirement savings account that your employer sets up for you. Money comes out of your paycheck before taxes are taken out, goes into an investment account in your name, and grows over time. Your employer may add money to it too — that's called a match. When you turn 59½, you can take the money out without penalty. If you leave your job, the money stays yours.

The main reason people use 401(k)s is the tax break. Because the money comes out before income tax, you pay less tax now. You will pay taxes later when you withdraw the money in retirement, but by then you may be in a lower tax bracket. Some employers also match what you contribute — meaning they give you information programs — which is why financial advisors often say a 401(k) match is the easiest return on investment you can get.

Key Takeaways

  • Your employer must offer a 401(k) plan for you to have one; it is not something you set up on your own.
  • Money you contribute comes out of your paycheck before income tax, lowering your taxable income for that year.
  • Your employer may match a portion of what you contribute, usually up to 3 to 6 percent of your salary.
  • You can withdraw money without penalty starting at age 59½, though some plans allow loans or hardship withdrawals before then.
  • If you leave your job, you can roll the money into a new employer's plan or into an individual retirement account (IRA).

How contributions work and what you can contribute

When you enroll in your company's 401(k), you choose what percentage of each paycheck to contribute. This amount is deducted before your employer calculates income tax, which means your take-home pay is lower but your taxable income for the year is also lower. The IRS sets a limit on how much you can contribute each year — this limit changes annually and is higher if you are 50 or older. Your plan administrator or HR department can tell you the current limit.

Your employer may offer a match, which is money they add to your account based on what you contribute. A common match is 50 cents for every dollar you contribute, up to 6 percent of your salary. This means if you earn $50,000 and contribute 6 percent ($3,000), your employer adds $1,500. If you contribute less than 6 percent, they match only what you put in. If you contribute more than 6 percent, they still only match up to 6 percent. Not all employers offer a match, and the terms vary by company.

Investment options within your plan

Your 401(k) money does not sit in a savings account earning interest. Instead, it is invested in funds — usually mutual funds or target-date funds — that you choose from a menu your plan provides. The plan administrator selects which funds are available, so your choices depend on your employer's plan. Common options include stock funds, bond funds, money market funds, and target-date funds that automatically shift from stocks to bonds as you get closer to retirement.

You decide how to split your contributions among these options. If you are young and have decades until retirement, you might choose mostly stock funds because they have higher growth potential over long periods. If you are closer to retirement, you might choose more conservative options like bonds. Many plans also offer a "default" fund — if you do not choose, your money goes there automatically. Some plans now default to a target-date fund based on your expected retirement year, which adjusts automatically as you age.

Employer matching and how to maximize it

An employer match is information programs, and it is one of the strongest reasons to contribute to a 401(k) if your employer offers one. To get the full match, you must contribute at least the percentage your employer matches. If your employer matches 100 percent up to 3 percent of salary, you need to contribute at least 3 percent to get all of it. If you contribute only 2 percent, you get only a 2 percent match from your employer.

The match vests over time, meaning you do not own it when ready. Vesting is the schedule your employer uses to give you ownership of their contributions. Some employers use when ready vesting (you own the match right away), while others use a schedule where you own more each year you stay. If you leave before you are fully vested, you lose the unvested portion. Your plan documents or HR department will tell you your vesting schedule. Even if you are not fully vested in the match yet, the money you contribute yourself is always yours.

Withdrawal rules and penalties

You can withdraw money from your 401(k) starting at age 59½ without paying an early withdrawal penalty. Before that age, withdrawals are subject to a 10 percent penalty on top of income tax. However, some plans allow you to borrow from your own contributions (not the employer match) and pay yourself back with interest. Other plans allow hardship withdrawals for specific situations like medical bills, home purchase, or education costs, though these still trigger taxes and penalties.

Once you turn 73, the IRS requires you to take minimum withdrawals each year, called required minimum distributions (RMDs). The amount is based on your age and account balance. If you do not take the required amount, you pay a penalty. If you are still working and your employer allows it, you may be able to delay RMDs until you actually retire. Your plan administrator will notify you when RMDs begin and calculate the amount you must withdraw.

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

When you leave your job, your 401(k) stays in your name — your employer cannot take it. You have several options for what to do with it. You can leave it in your former employer's plan if the balance is above a certain amount (usually $5,000). You can roll it into your new employer's 401(k) plan if they accept rollovers. You can roll it into an individual retirement account (IRA), which gives you more investment choices. Or you can cash it out, though this triggers income tax and a 10 percent penalty if you are under 59½.

A rollover is usually the best option because it keeps the money growing tax-deferred and avoids penalties. If you roll into an IRA, you have access to a much wider range of investments than most 401(k) plans offer. If you roll into a new employer plan, your investments are limited to what that plan offers, but you keep everything in one place. Do not cash out unless you have no other option — the tax bill and penalty can be substantial, and you lose years of growth on that money.

Understanding vesting and ownership

Vesting determines when you own the money your employer contributes. Your own contributions are always 100 percent vested when ready — that money is yours from day one. But the employer match or any employer contribution follows a vesting schedule set by the plan. Common schedules include when ready vesting (you own it right away), cliff vesting (you own nothing until a certain date, then own it all at once), or graded vesting (you own a percentage each year).

If your plan uses cliff vesting and you leave before the cliff date, you lose all the employer contributions. If it uses graded vesting and you leave after three years of a five-year schedule, you own 60 percent of the employer money and lose 40 percent. Your plan documents spell out the exact schedule. If you are considering leaving a job, check your vesting schedule first — sometimes waiting a few months until the next vesting date means keeping thousands of dollars in employer contributions.

Frequently Asked Questions

Can I contribute to a 401(k) if I am self-employed?

No — a 401(k) must be offered by an employer. If you are self-employed, you can open a Solo 401(k) (for yourself only) or a SEP IRA, which work similarly but are set up differently. Talk to a tax professional about which fits your situation.

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

Your 401(k) goes to whoever you named as your beneficiary on the plan documents. If you did not name anyone, it goes through your estate. Beneficiaries can usually roll the money into an inherited IRA or take it out over time. Check your beneficiary designation every few years to make sure it reflects your wishes.

Can I borrow from my 401(k)?

Many plans allow loans from your own contributions, but not all. If your plan allows it, you typically borrow up to 50 percent of your balance (with a maximum around $50,000) and repay it with interest over five years. Loans are not taxed, but if you leave your job before repaying, the loan becomes a withdrawal and triggers taxes and penalties.

What is the difference between a 401(k) and a 403(b)?

A 403(b) is similar to a 401(k) but is offered by nonprofits, schools, and government agencies instead of for-profit companies. The contribution limits and rules are nearly identical, but 403(b)s typically have fewer investment options and sometimes lower fees.

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

No — participation is voluntary. However, if your employer offers a match, not contributing means leaving information programs on the table. Most financial advisors recommend contributing at least enough to get the full match.