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What is a 401(k)?
A 401(k) is a retirement savings and investing plan offered only by employers. An employee enrolled in a 401(k) plan can have their contribution taken automatically out of their paycheck, with their employer matching all or part of that amount. The money is then invested in funds of an employee’s choosing from a list of available offerings.
Why is it called a 401(k)? The catchy name comes from the section of the tax code — specifically subsection 401(k) — that established this type of plan.
What if you don't have access to a 401(k) plan? 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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401(k) plan pros
Your employer might offer a match. This is essentially free money if you’re able to meet the match.
The money you contribute is all yours. If you leave your job, you can take your 401(k) plan with you and either roll it into your new employer’s 401(k) plan or your own IRA. You may be able to take your employer’s contributions as well, but it depends on their vesting schedule.
401(k) plan cons
Only offered by employers to their employees. If you are self-employed, you could set up a solo 401(k) with an online broker. There won’t be any free money, but the contributions limits are higher — up to $66,000 to a solo 401(k) in 2023 and $69,000 in 2024.
Potentially more limited investment options and support. Your investment options with a 401(k) depend on your employer’s plan provider. You’ll also likely need to come up with an investment strategy and monitor the plan yourself.
» Estimate how your 401(k) plan will grow with our 401(k) calculator.
How does a 401(k) work?
A benefit of the 401(k) is that it automates saving for retirement and makes investing easier. Your contribution gets taken out of your paycheck, your employer’s matching contribution is automatically added to your account, and — depending on the type of 401(k) plan you choose — you could get some pretty useful tax advantages.
» See how you compare Find the average 401(k) balance by age.
Traditional 401(k) vs. Roth 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. (Here are the contribution limits to shoot for this year.)
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.
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.
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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.
Both the Roth and traditional 401(k)s have rules around withdrawals. There are a few exceptions, but in general, the IRS says you cannot take distributions from your account until age 59½ without running into additional taxes or penalties.
Starting in 2024, plan participants will be able to make a hardship withdrawal for emergency expenses of up to $1,000.
» Still not sold on investing? Learn how inflation can impact your savings — and how investing can boost it — with our inflation calculator.
401(k) changes for 2024
Because of rising inflation, the amount you can contribute annually to your 401(k) plans has also increased. Individuals could contribute$22,500 in 2023 ($30,000 for those age 50 or older). For 2024, the limit rises to $23,000 ($30,500 for those age 50 or older).
And if you are not participating in your company's 401(k) plan, take note. Under a spending bill signed by President Biden, starting in 2025, employers will be required to automatically enroll participants in 401(k) and 403(b) plans once employees are eligible.
The automatic contribution starts at at least 3%. The contributions taken out of your paycheck will increase by 1% a year until your annual contribution is at least 10%, but not more than 15%. The legislation says all current 401(k) and 403(b) plans are automatically included.
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