What a 401(k) is and how the money moves

A 401(k) is a retirement savings account that your employer sets up, and you contribute to it through automatic payroll deductions. The money comes out of your paycheck before taxes are calculated, which lowers your taxable income for that year. Your employer may also add money to your account — this is called a match — though they are not required to.

The account holds investments you choose from a menu your employer's plan provides. Common options include mutual funds, target-date funds (which shift from stocks to bonds as you near retirement), and sometimes company stock. The money grows tax-free inside the account until you withdraw it. When you take money out after age 59½, you pay income tax on the full amount you withdraw.

If you leave your job, you can take your 401(k) with you by rolling it into an Individual Retirement Account (IRA) at a bank or brokerage, or into your new employer's plan if they allow it. The money stays invested and keeps growing tax-free. If you withdraw money before age 59½ without a valid reason, you pay income tax plus a 10% penalty.

Key Takeaways

  • Money you put into a 401(k) reduces your taxable income that year, and the account grows tax-free until you withdraw after age 59½.
  • Your employer may match a portion of what you contribute — this is assistance programs and the most common reason to join a plan.
  • You choose how to invest the money from a limited menu your employer's plan provides, and you can change your choices once a year or when your life changes.
  • When you leave a job, you can roll your 401(k) into an IRA or your new employer's plan to keep the money invested and avoid taxes and penalties.
  • Withdrawing money before age 59½ triggers a 10% penalty plus income tax, with narrow exceptions for hardship, disability, or death.

How much you can contribute and what your employer might add

The amount you can put into a 401(k) changes each year. For 2024, the limit is $23,500 if you are under age 50, and $31,000 if you are 50 or older (the extra $7,500 is called a catch-up contribution). Your employer can set a lower limit if they choose, so check your plan documents to see what your workplace allows.

An employer match is separate from your contribution limit. If your employer matches 50% of the first 6% you contribute, that means if you put in 6% of your salary, they add 3%. The match is assistance programs — it does not count against your contribution limit. Not all employers offer a match, and those who do vary widely in how much they contribute. Some match dollar-for-dollar up to a certain percentage; others match 25 or 50 cents on the dollar.

To get the full match, you usually have to contribute at least the percentage your employer specifies. If you contribute less, you get a smaller match or none at all. If you contribute more than the match threshold, the extra money is still yours and still grows tax-free, but your employer does not add to it.

Vesting: when the employer's money becomes yours

Vesting means the point at which money your employer contributed becomes legally yours to keep. Your own contributions are always yours immediately — vesting only applies to employer matches and other employer contributions.

Some employers use immediate vesting, meaning the match is yours the day it hits your account. Others use a vesting schedule, which means you own a percentage of the employer's contribution based on how long you have worked there. A common schedule is 20% per year — after five years, you own 100% of the match. If you leave before you are fully vested, you forfeit the unvested portion and it goes back to the employer.

Your plan documents spell out the vesting schedule. If you are considering leaving a job, check when you will be fully vested. Staying a few extra months might mean keeping thousands of dollars in employer contributions.

How investment choices work and what happens to your money

When you enroll in a 401(k), you choose how to split your contributions among the investments your plan offers. These typically include stock mutual funds, bond mutual funds, money market funds, and target-date funds. A target-date fund automatically shifts from aggressive (mostly stocks) to conservative (mostly bonds) as you approach a specific retirement year you choose.

You can usually change your investment choices once a year during an open enrollment period, or immediately if you have a major life change like marriage, divorce, birth of a child, or job loss. Some plans let you change more often. The money already invested stays in its current investment unless you move it; only new contributions go to your new choices.

Your employer's plan administrator — a company hired to run the plan — holds the money and handles the investments. You do not own the actual stocks or bonds; you own shares in mutual funds that hold them. The funds charge fees, which come out of your account balance. These fees vary widely, from under 0.1% per year to over 1%, so it is worth comparing if your plan shows you the fee information.

Tax treatment: now versus later

A traditional 401(k) works like this: you contribute pre-tax money, which lowers your taxable income this year. The money grows tax-free. When you withdraw it in retirement, you pay income tax on the full amount at whatever tax rate applies then. If you withdraw before age 59½, you also pay a 10% penalty (with narrow exceptions).

Some employers also offer a Roth 401(k), which works differently. You contribute after-tax money — it does not lower your taxable income this year. But the money grows tax-free, and when you withdraw it after age 59½, you pay no tax on it at all. The catch is you pay taxes now instead of later. Roth 401(k)s make sense if you expect to be in a higher tax bracket in retirement, or if you want to leave tax-assistance programs to your heirs.

You can contribute to both a traditional and Roth 401(k) in the same year, but your combined contributions cannot exceed the annual limit ($23,500 for 2024 if you are under 50).

What happens when you leave your job

When you leave an employer, you have several options for your 401(k). You can leave it where it is if your balance is above a certain amount (usually $5,000, though this varies by plan). You can roll it into an IRA at a bank, brokerage, or credit union — this keeps the money invested and growing tax-free. You can roll it into your new employer's 401(k) if they accept rollovers. Or you can cash it out, though this triggers income tax on the full amount plus a 10% penalty if you are under 59½.

A direct rollover is the safest route: the money moves directly from your old plan to the new account without passing through your hands. If you take the money yourself and deposit it within 60 days, it is called an indirect rollover, but your employer withholds 20% for taxes, so you have to make up that 20% from your own pocket or it counts as a withdrawal and you owe taxes and penalties on it.

If your old employer's plan requires you to move the money because your balance is small, they will tell you how to do it. Do not ignore these notices — if you do not move the money within the deadline, the plan may cash it out and send you a check, triggering the tax and penalty.

Early withdrawal exceptions and hardship rules

Normally, withdrawing before age 59½ costs you 10% plus income tax. But the IRS allows exceptions for specific situations. You can withdraw without the 10% penalty if you are disabled, if you are a beneficiary receiving money after someone's death, if you have substantial medical expenses, or if you are separated from service and take Substantially Equal Periodic Payments (SEPP) — a series of equal withdrawals calculated by IRS formulas.

Some plans also allow hardship withdrawals for immediate financial need: medical bills, preventing eviction or foreclosure, funeral expenses, or education costs. Hardship withdrawals still trigger income tax, but not the 10% penalty. Your plan administrator decides whether your situation qualifies, and you usually have to show you have no other way to pay. Hardship rules vary by plan, so ask your plan administrator what your plan allows.

Taking a loan from your 401(k) is another option some plans offer. You borrow from your own account and repay it with interest. If you leave your job before repaying the loan, the unpaid balance is treated as a withdrawal and you owe taxes and penalties on it.

Other employer retirement plans: 403(b)s, 457s, and SEP IRAs

Not all employers offer 401(k)s. Schools, hospitals, and nonprofits typically offer 403(b) plans, which work almost identically to 401(k)s — same contribution limits, same tax treatment, same vesting rules. The main difference is that 403(b)s traditionally invested in annuities, though many now offer mutual funds like 401(k)s do.

Government employees may have access to a 457 plan, which also works similarly but has different rules: you can withdraw money after you leave your job without the 10% penalty, even if you are under 59½. The contribution limit is the same as a 401(k).

Small business owners and self-employed people can set up a SEP IRA (Simplified Employee Pension), which allows much higher contributions — up to 25% of net self-employment income, with a 2024 limit of $69,000. A SEP IRA is simpler to administer than a 401(k) and has lower fees, but it does not allow employer matches in the traditional sense.

Frequently Asked Questions

What if my employer does not offer a 401(k)?

You can open an Individual Retirement Account (IRA) on your own at a bank or brokerage. For 2024, you can contribute up to $7,000 per year if you are under 50 ($8,000 if you are 50 or older). An IRA does not have an employer match, but it gives you full control over your investments and lower fees than many 401(k)s.

Can I withdraw money from my 401(k) to buy a house?

You can take a loan from your 401(k) if your plan allows it, but you cannot withdraw for a down payment without penalties and taxes unless you are a first-time homebuyer and your plan has a specific provision for it (most do not). A hardship withdrawal is possible in some plans, but it still triggers income tax. An IRA has a one-time exception: first-time homebuyers can withdraw up to $10,000 without the 10% penalty, though you still pay income tax.

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

The money goes to whoever you named as your beneficiary on the plan form. They can roll it into an inherited IRA and take withdrawals over time, or cash it out. The money is not subject to the 10% early withdrawal penalty, but it is subject to income tax. Make sure your beneficiary designation is current — it overrides your will.

Should I contribute to my 401(k) if I have credit card debt?

If your employer offers a match, contribute enough to get the full match — that is an immediate return on your money. After that, paying off high-interest credit card debt (usually 15% or higher) often makes more financial sense than contributing extra to a 401(k), since the may provide return from eliminating debt is higher than typical investment returns.

Can I have both a 401(k) and an IRA?

Yes. You can contribute to both in the same year, but there are income limits on deducting IRA contributions if you have a 401(k) and earn above a certain amount. For 2024, if you are single and covered by a 401(k), you cannot deduct IRA contributions if your income exceeds $77,000. Check the current limits with the IRS or a tax professional, as they change yearly.