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

A starter guide to 401(k) plans, how they work, and how you can use one to prepare for retirement.
June Sham
Dayana Yochim
By Dayana Yochim and  June Sham 
Updated
Edited by Chris Hutchison Reviewed by Jody D’Agostini

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Nerdy takeaways
  • For the most common types of 401(k) plans, they can only be obtained through an employer.

  • Saving for retirement through a 401(k) plan is one of the easiest ways to prepare for retirement, particularly with its tax advantages and potential employer match, but a downside could be more limited investment options compared with an IRA.

  • Employees historically have had to opt into their workplace retirement plan, but as of Jan. 1, 2025, employers will be required to automatically enroll participants in 401(k) and 403(b) plans once employees are eligible.

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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 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 some employee contributions.

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

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

Don't have access to a 401(k) plan or want to further maximize your retirement savings? Enter the IRA: These accounts offer some attractive benefits (a broader selection of investments and generally lower fees), albeit with a few downsides (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? Check out the best IRA accounts available now.

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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 can select your investments based on what’s offered by your employer’s plan provider.

Depending on the type of 401(k) plan you chose, you could get some pretty useful tax advantages either when you contribute the money, or when you make withdrawals in retirement.

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

Traditional 401(k) vs. Roth 401(k)

There are two main types of 401(k) plans — the traditional and Roth — which are differentiated by their tax-advantages.

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. For example, let’s say you make $65,000 a year and put $19,500 into your 401(k). Instead of paying income taxes on the entire $65,000 you earned, you’ll only owe tax on $45,500 of your salary. In other words, saving for the future lets you shield $19,500 from taxation.

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 distributions.

How’s that, exactly? Remember we mentioned earlier that, depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement? Well, the IRS can charge you income taxes only once.

You’ve already paid your due because your contributions were made with post-tax dollars. And any income you get from the account – dividends, interest or capital gains – grows tax-free, and when you withdraw money in retirement, you and Uncle Sam are already settled up.

As of January 2024, plan participants can make a hardship withdrawal for emergency expenses of up to $1,000.

Senate.gov. SECURE 2.0 Act of 2022. Accessed Sep 26, 2023.

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

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