What Is a 401(k) and How Does It Work?
What Is a 401(k) and How Does It Work?
If you have a job in the United States, there's a good chance your employer offers a 401(k) plan. It's the most common retirement savings tool in America — but a surprising number of people don't fully understand how it works or how to get the most out of it.
Here's everything you need to know.
What Is a 401(k)?
A 401(k) is a tax-advantaged retirement savings account offered through your employer. You contribute a portion of your paycheck into the account, and that money grows over time through investments — typically mutual funds, index funds, or target-date funds.
The name comes from the section of the U.S. tax code that created it: Section 401(k).
How Does a 401(k) Work?
Step 1: You contribute from your paycheck You choose a percentage of your salary to contribute automatically. This happens before taxes are taken out (for a traditional 401(k)), which reduces your taxable income today.
Step 2: Your employer may match your contribution Many employers match a portion of what you contribute — often 50% or 100% up to a certain percentage of your salary. This is free money. Always contribute at least enough to get the full match.
Step 3: Your money is invested Your contributions go into investment options chosen by your employer's plan. Most people choose a target-date fund set to their expected retirement year.
Step 4: Your money grows tax-deferred You don't pay taxes on gains, dividends, or interest while the money is in your 401(k). You only pay taxes when you withdraw in retirement.
Traditional 401(k) vs Roth 401(k)
| Traditional 401(k) | Roth 401(k) | |
|---|---|---|
| Contributions | Pre-tax | After-tax |
| Tax break | Now (reduces income today) | Later (withdrawals tax-free) |
| Best for | Higher earners now | Younger/lower earners now |
| Withdrawals | Taxed as income | Tax-free |
If you're early in your career and expect to earn more later, Roth often makes more sense. If you're in your peak earning years, traditional usually wins.
2026 Contribution Limits
| Who | Annual Limit |
|---|---|
| Under age 50 | $23,500 |
| Age 50 or older (catch-up) | $31,000 |
The Power of Employer Matching
Employer matching is the closest thing to free money you'll ever find. Here's how it works:
Example: Your employer matches 100% of contributions up to 4% of your salary. You earn $60,000/year.
- 4% of $60,000 = $2,400 you contribute
- Employer adds $2,400 for free
- Total going into your 401(k): $4,800/year
If you only contribute 2%, you leave $1,200 on the table every year. Over a career, that's tens of thousands of dollars in lost savings.
What Happens If You Withdraw Early?
If you withdraw money before age 59½, you'll face:
- Income taxes on the amount withdrawn
- 10% early withdrawal penalty
There are limited exceptions (serious illness, first home purchase under certain conditions, etc.), but in general, your 401(k) money should stay untouched until retirement.
How Much Should You Contribute?
A common guideline:
- First: Contribute enough to get the full employer match (minimum)
- Then: Max out a Roth IRA ($7,000/year in 2026)
- Then: Go back and contribute more to your 401(k) up to the limit
If you can only do one thing, do #1. Getting the full employer match should be non-negotiable.
See How Much Your 401(k) Could Grow
Use our free calculator to see your projected 401(k) balance at retirement based on your current contributions and salary.
👉 Try the 401(k) Calculator →
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