What Is a 401(k) Plan?

What Is a 401(k) Plan?

Let me explain what a 401(k) plan really is—it's a tax-advantaged retirement savings plan named after a section of the U.S. Internal Revenue Code, functioning as a defined-contribution plan your employer provides. Your employer might match your contributions, and in some cases, that match is required.

You'll encounter two main types: traditional and Roth. In a traditional 401(k), your contributions come pretax, lowering your taxable income now, but you'll pay taxes on withdrawals during retirement. With a Roth 401(k), you contribute after-tax income, so there's no upfront deduction, but qualified withdrawals are tax-free.

Key Takeaways

Understand that a 401(k) is a company-sponsored account where you contribute a portion of your income, and employers often match some of it. The traditional and Roth versions differ mainly in taxation—pretax for traditional, after-tax for Roth with tax-free growth. Employers can contribute to either type, and solo 401(k)s exist for those without employers. Remember, there are strict rules on penalty-free withdrawals.

How 401(k)s Work

Traditional 401(k)s started in the early 1980s, letting you make pretax contributions up to set limits. When you enroll, you agree to deposit a percentage of each paycheck into an investment account, and your employer might match part or all of it. You select investments from your employer's options, usually including stock and bond mutual funds or target-date funds that get more conservative as retirement nears. Your account might also hold guaranteed investment contracts or even your employer's stock.

How Do You Start a 401(k)?

Reach out to your employer to check if a 401(k) is available and if they offer a match—they often mention this during hiring. If it's offered, they'll guide you through signup. Pick your investments from the range provided, from conservative to aggressive; target-date funds are common, adjusting automatically toward conservatism as you approach retirement. If you're self-employed or run a small business with your spouse, consider a solo 401(k) through an online broker to fund your own retirement.

Traditional 401(k)s

With a traditional 401(k), contributions deduct from your gross income before taxes, reducing your taxable income and allowing a deduction that year. You won't pay taxes on contributions or earnings until withdrawal, typically in retirement.

Roth 401(k)s

Roth 401(k)s came later in 2006, named after Senator William Roth. Contributions use after-tax income, so no deduction now, but withdrawals in retirement are tax-free, including earnings. If you expect a lower tax bracket in retirement, go traditional for the immediate break; if higher, choose Roth for tax-free growth over time. Roth reduces your current spending power more, which matters if money is tight. Generally, early withdrawals before 59½ have tax consequences—consult an advisor first.

401(k) Plan Contribution Limits

Both traditional and Roth are defined contribution plans, with IRS-set limits adjusted for inflation. For 2025, under-50 workers can contribute up to $23,500, plus $7,500 catch-up for those 50 and older. Aim to max it out if possible, as it's a solid way to build savings.

Employer Matching

For under-50 workers, combined employee-employer contributions cap at $70,000 in 2025, or $77,500 with catch-up. Employers use formulas like matching $0.50 per $1 up to a salary percentage. Always take the match—it's free money without sacrificing other goals like debt payoff or emergency funds.

How Does Your 401(k) Earn Money?

Your contributions go into investments you choose from employer options, like target-date or mutual funds. Target-date funds minimize mistakes by shifting to conservative assets as retirement nears. Growth depends on your contributions, matches, performance, and time horizon. Traditional plans offer tax-deferred growth; Roth provides tax-free. Compounding reinvests returns, potentially exceeding your inputs over years.

401(k) Withdrawals

Withdrawing from a 401(k) is tricky without taxes—save elsewhere for emergencies. Traditional withdrawals are taxed as income; Roth qualified ones are tax-free. You need to be 59½ or qualify for hardship to avoid a 10% penalty. Some plans allow loans against contributions.

Required Minimum Distributions

Traditional 401(k) holders must take RMDs starting at age 73, based on life expectancy, or face penalties. This doesn't apply to Roth.

History of the 401(k)

Defined contribution plans like 401(k)s have overtaken traditional pensions, shifting retirement risk to employees. About a third of working-age Americans have a 401(k), far more than pensions, though many have none.

What Happens to Your 401(k) When You Leave a Job?

You have options: Withdraw (taxable, often penalized—avoid unless necessary), roll into an IRA (tax-advantaged, more choices), leave with former employer (if over $5,000, no further contributions), or move to new employer's plan (maintains status).

Frequently Asked Questions

The 2025 max is $23,500 under 50, plus $7,500 catch-up, with combined limits up to $70,000 or $77,500. Early withdrawals are rarely wise due to penalties and taxes, though hardships may qualify. Stock sell-offs reduce value temporarily—stay invested.

The Bottom Line

A 401(k) lets you contribute annually up to limits for retirement, with traditional offering pretax benefits and Roth tax-free withdrawals, plus employer contributions to enhance savings.