What a 401(k) Is and How Money Moves Into It

A 401(k) is a retirement savings account that your employer sets up. Money comes out of your paycheck before taxes are taken out, goes into an investment account held in your name, and stays there until you reach age 59½ or leave the job. The account is named after a section of the tax code, not after what it does — but what it does is let you set aside money for retirement while reducing your taxable income in the year you contribute.

You choose how much to contribute each pay period, up to a limit set by the IRS. For 2024, that limit is $23,500 per year if you are under 50, and $31,000 if you are 50 or older. Your employer deducts your chosen amount from each paycheck and deposits it into your 401(k) account. The money is invested according to choices you make from a menu of funds — usually a mix of stock funds, bond funds, and money market funds.

The account belongs to you. If you leave the job, the money stays in the account or you can move it to another retirement account. If you stay at the job until retirement, you can start withdrawing money at 59½ without penalty. If you withdraw before that age, you generally owe income tax plus a 10 percent penalty on the amount withdrawn.

Key Takeaways

  • A 401(k) is a retirement account funded by money taken from your paycheck before income tax, which lowers your taxable income for the year.
  • Your employer may match a portion of what you contribute — for example, 50 cents for every dollar you put in, up to 3 percent of your salary — and this match is assistance programs you should not leave unclaimed.
  • You choose how your money is invested from a list of funds your employer's plan offers, and you can change your choices once a year or when your life changes.
  • Money in a 401(k) grows tax-free while it sits in the account, but you pay income tax on withdrawals after age 59½, and withdrawals before that age usually trigger a 10 percent penalty.
  • If you leave your job, you can roll the money into another 401(k), an IRA, or leave it where it is, depending on your plan rules and the new employer's plan.

The Employer Match: Why It Matters

Many employers offer a match — they contribute money to your 401(k) based on how much you contribute. A common match is 50 percent of what you contribute, up to 3 percent of your salary. That means if you earn $50,000 and contribute 3 percent ($1,500), your employer adds $750. If you contribute only 1 percent ($500), your employer adds $250.

The match is not automatic. You have to contribute first. If you do not contribute, your employer does not match. This is why financial advisors often say: contribute at least enough to get the full match. It is the only may provide return on your money. If your employer matches 50 cents on the dollar up to 3 percent of salary, you are getting an immediate 50 percent return on that portion of your contribution.

Match amounts vary widely by employer. Some match dollar-for-dollar up to 3 percent. Others match 25 cents on the dollar up to 6 percent. Some do not offer a match at all. When you start a job, ask your HR department or benefits administrator what the match formula is, and calculate the minimum you need to contribute to capture it all.

How Taxes Work With a 401(k)

Money you put into a traditional 401(k) reduces your taxable income for the year you contribute. If you earn $60,000 and contribute $6,000 to your 401(k), you report only $54,000 as taxable income. This lowers your federal income tax bill for that year.

The money grows inside the account without being taxed each year. If your $6,000 investment grows to $8,000, you do not owe tax on that $2,000 gain while it sits in the account. You pay tax only when you withdraw the money, usually after you retire.

When you withdraw money after age 59½, you pay income tax on the full amount withdrawn — both your contributions and all the growth. If you withdraw before 59½, you owe income tax plus a 10 percent early withdrawal penalty, unless you may have access to for a narrow exception (such as a hardship withdrawal, which has strict rules and still requires you to pay tax).

Some employers offer a Roth 401(k) option, where you contribute after-tax money but withdrawals in retirement are tax-free. The choice between traditional and Roth depends on whether you expect to be in a higher or lower tax bracket in retirement — a question worth discussing with a tax professional or financial advisor.

Investment Choices and How Your Money Grows

Your employer's 401(k) plan offers a menu of investment funds, typically ranging from 10 to 30 options. Common choices include stock index funds (which track the overall stock market), bond funds (which tend to be less volatile), target-date funds (which automatically shift from stocks to bonds as you approach retirement), and money market funds (which are very stable but offer low returns).

You decide how to split your contributions among these funds. A common approach for younger workers is to put most money in stock funds, since stocks historically grow faster over long periods and you have time to recover from downturns. As you approach retirement, many people shift toward bonds and stable funds to reduce risk.

You can change your investment choices once a year, or whenever your life changes significantly (marriage, birth of a child, job change). Some plans allow more frequent changes. Check your plan documents or ask your benefits administrator how often you can rebalance.

What Happens When You Leave Your Job

If you leave your job, you have several options for the money in your 401(k). You can leave it in your former employer's plan if the balance is above a certain amount (usually $5,000). You can roll it into your new employer's 401(k) if the new plan accepts rollovers. You can roll it into an IRA (Individual Retirement Account), which often offers more investment choices. Or you can cash it out, though this triggers income tax and the 10 percent early withdrawal penalty if you are under 59½.

A rollover is usually the best option because it keeps the money growing tax-free and avoids penalties. The money moves directly from one account to another — you do not touch it. If you cash out, you lose the tax-deferred growth and pay penalties, which can take a large bite out of your savings.

If you leave your job and do nothing, your money typically stays in the old plan. But it stops growing as quickly because you are no longer contributing, and you may face higher fees. Most financial advisors recommend rolling over to an IRA or new employer plan within 60 days of leaving a job.

Contribution Limits and Catch-Up Contributions

The IRS sets an annual limit on how much you can contribute to a 401(k). For 2024, the limit is $23,500 if you are under 50. If you are 50 or older, you can contribute an additional $7,500 per year, for a total of $31,000. These limits change most years to keep pace with inflation.

Your employer may also set a limit lower than the IRS limit, or may stop matching contributions once you reach a certain amount. Check your plan documents to see what your specific plan allows.

If you have not saved much for retirement and are now in your 50s or 60s, the catch-up contribution option lets you put away more money in the years before retirement. This is one of the few ways the tax code lets you make up for lost time.

Fees and What They Cost You

Most 401(k) plans charge fees. These come in three forms: plan administration fees (paid by the employer or deducted from your account), investment fees (charged by the fund companies managing your money), and sometimes advisor fees if you use a financial advisor through the plan.

Investment fees are usually stated as an expense ratio — a percentage of your account balance charged each year. A fund with a 0.5 percent expense ratio costs you $50 per year for every $10,000 invested. A fund with a 1.5 percent expense ratio costs $150 per year on the same balance. Over decades, the difference compounds significantly.

When you enroll, ask your benefits administrator for a fee disclosure document. Compare the expense ratios of the funds offered. Index funds — which simply track a market index rather than trying to beat it — typically have lower fees than actively managed funds. Lower fees mean more of your money stays invested and grows for you.

Frequently Asked Questions

Can I withdraw money from my 401(k) before age 59½?

You can, but you will owe income tax plus a 10 percent penalty on the amount withdrawn. Some plans allow hardship withdrawals for specific situations like medical bills or preventing eviction, but these still require you to pay tax. A few narrow exceptions exist — such as substantially equal periodic payments if you retire before 59½ — but these have strict rules. Talk to a tax professional before withdrawing early.

What happens to my 401(k) if I die?

The money goes to whoever you named as your beneficiary on the account. If you did not name anyone, it goes to your estate and may go through probate. Name a beneficiary when you enroll, and review that choice after major life events like marriage or divorce. Your beneficiary can usually roll the money into an IRA or take distributions over time.

Can I borrow from my 401(k)?

Many plans allow loans. You can typically borrow up to 50 percent of your account balance, up to $50,000. You repay the loan with interest, and the interest goes back into your account. If you leave your job before repaying, the loan is usually due immediately or treated as a withdrawal, triggering taxes and penalties. Borrowing from retirement savings slows your long-term growth, so use this option only as a last resort.

What is the difference between a 401(k) and an IRA?

A 401(k) is offered by your employer and funded through payroll deductions. An IRA is an individual account you open on your own. 401(k)s have higher contribution limits and often include an employer match. IRAs offer more investment choices and lower fees. Many people have both — they contribute to their employer's 401(k) to capture the match, then open an IRA for additional retirement savings.

Do I have to contribute to my employer's 401(k)?

No, it is voluntary. But if your employer offers a match, not contributing means leaving assistance programs on the table. Even if there is no match, a 401(k) is a tax-advantaged way to save for retirement. If your employer offers one and you can afford to contribute, it is usually worth doing.