401(k): What It Is and How It Works

A 401(k) plan is a tax-advantaged retirement account employers offer to help their employees save for retirement. The two most common types of 401(k) plans are traditional and Roth.
June Sham
Dayana Yochim
By Dayana Yochim and  June Sham 
Edited by Chris Hutchison Reviewed by Jody D’Agostini

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Nerdy takeaways
  • Most 401(k) retirement plans are sponsored by employers, who may also offer a match when employees make a contribution.

  • The most common types of 401(k) plans are the traditional and Roth, each offering its own tax benefit.

  • You can contribute $23,000 to your 401(k) in 2024 ($30,500 for those age 50 or older).

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What is a 401(k)?

A 401(k) plan is a tax-advantaged retirement account designed to help people prepare for retirement. The most common type of 401(k) plan is a traditional 401(k), offered through an employer to employees, who can contribute part of their salary to be invested in 401(k) accounts. While not required, many employers match a percentage of employee contributions.

» Estimate how your 401(k) plan will grow with our 401(k) calculator.

Like other retirement plans, the IRS adjusts 401(k) contribution limits periodically. In 2024, individuals can contribute $23,000 in 2024 ($30,500 for those age 50 or older).

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How does a 401(k) work?

A 401(k) plan works by investing employee contributions, and employer matches, if offered, over time. After enrolling in your 401(k) plan, you may be able to select your investments — typically target-date funds and other mutual funds — based on what’s offered by your employer’s plan provider.

The two main types of 401(k) plans are traditional and Roth, and they are differentiated by their tax-advantages. Depending on the type of 401(k) plan you chose, you could get the tax benefits when you contribute the money (traditional), or when you make withdrawals in retirement (Roth). While traditional 401(k) plans are more common, many employers now offer Roth 401(k)s as well.

» A step-by-step guide on how to set up your 401(k)

Traditional 401(k)

Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, and your money grows tax-free. Let’s say Uncle Sam normally takes 20 cents of every dollar you earn to cover taxes. Saving $800 a month outside of a 401(k) requires earning $1,000 a month — $800, plus $200 to cover the IRS’ cut.

Besides the boost to your savings power, pretax contributions to a traditional 401(k) have another nice side effect: They lower your total taxable income for the year.

Once the money is in your 401(k), the force field that protects it from taxation remains in place. This is true for both traditional and Roth 401(k)s. As long as the money remains in the account, you pay no taxes on any investment growth: Not on interest, not on dividends and not on any investment gains

IRS. 401(k) Plan Overview. Accessed Sep 26, 2023.

But the tax-repellent properties of the traditional 401(k) don’t last forever. Remember when you got that tax deduction on the money you contributed to the plan? Well, eventually the IRS comes back around to take a cut. In technical terms, your contributions and the investment growth are tax-deferred — put off until you start making withdrawals from the account in retirement. At that point, you’ll owe income taxes.

Traditional 401(k)s have one more caveat: after a certain age, account holders must take required minimum distributions, which aren’t required with a Roth 401(k).

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Roth 401(k)

If your employer offers a Roth 401(k) – and not all do – you can contribute after-tax income and your distributions will be tax-free in retirement.

The Roth 401(k) offers the same tax shield as a traditional 401(k) on your investments when they are in the account; you owe nothing to the IRS on the money as it grows. But unlike with qualified withdrawals from a regular 401(k), with a Roth, you owe the IRS nothing when you start taking qualified distributions as long as you are 59 1/2 and have held the account for five years.

That because you’ve already paid your taxes since your contributions were made with post-tax dollars. And any income you get from the account – dividends, interest or capital gains – grows tax-free. When you meet the requirements for a qualified withdrawal, you and Uncle Sam are already settled up.

» Choosing between the two? Here’s more on traditional vs Roth 401(k) plans.

Don't have access to a 401(k) plan or want to further maximize your retirement savings? Enter the individual retirement account: These accounts offer some attractive benefits, including a broader selection of investments and generally lower fees. But IRAs do have lower contribution limits and restrictions for high earners. An IRA is different from a 401(k), but you can have both as part of your retirement strategy.

» Interested in an IRA? See our picks for the best IRA accounts.


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401(k) withdrawals

While you can withdraw from your 401(k) at any time before age 59 1/2, you'll likely face a 10% early distribution penalty, except in select cases, or if you qualify for a hardship withdrawal. As of January 2024, plan participants can make a hardship withdrawal for emergency expenses of up to $1,000

. In either case, an early 401(k) withdrawal will still trigger taxes, and leave less money in the account to invest over time.

» Learn more: Get the details on 401(k) withdrawal rules

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