401(k): What It Is, How It Works, Pros, and Cons (2024)

What Is a 401(k)?

A 401(k) is a tax-advantaged retirement savings plan. Named after a section of the U.S. Internal Revenue Code, the 401(k) is an employer-provided, defined-contribution plan. The employer may match employee contributions; with some plans, the match is mandatory.

There are two major types of 401(k)s: traditional and Roth. With a traditional 401(k), employee contributions are pretax, meaning they reduce taxable income, but withdrawals in retirement are taxed. Employee contributions to Roth 401(k)s, on the other hand, are made with after-tax income. There’s no tax deduction in the contribution year, but withdrawals—qualified distributions—are tax free.

Below, we walk you through how to start a 401(k), how 401(k) plans work, and strategies for making the most of them.

“The most important thing to know when making any decision about your 401(k) is to use it. In a perfect world, you put the maximum amount in it, but at a minimum, you should contribute up to the point where your company matches what you put in,” said Peter Lazaroff, financial advisor and chief investment officer at Plancorp.

In 2023, Americans saved an average of 7.1% of their salaries in their 401(k)s, which was higher than the overall personal savings rate that year. Less than 12% of working-age Americans were on track in 2023 to max out their contributions. The 401(k) employee contribution limit for 2024 is $30,500 (including “catch-up” contributions) for those 50 and older and $23,000 for those under 50.

How Do You Start a 401(k)?

• Contact your employer. Ask if a 401(k) is available, and whether there is a company match.
• If a 401(k) is available, the company will instruct you how to sign up with new paperwork.
• Choose your investments. There should be a range of options, from conservative to aggressive. A popular option is the target date account, which automatically adjusts the asset mix to align with a preset retirement date. It typically becomes more conservative as you near retirement.
• If you are self-employed or run a small business with your spouse, you may be eligible for a solo 401(k) plan, also known as an independent 401(k). These plans allow independent contractors to fund their own retirement. A solo 401(k) can be created through most online brokers.

How 401(k)s Work

Introduced in the early 1980s, traditional 401(k) plans allow employees to make pretax contributions from their salaries up to certain limits.

When a worker signs up for a 401(k), they agree to deposit a percentage of each paycheck directly into an investment account. Employers often match part or all of that contribution.

Employees are also responsible for choosing the specific investments held within their 401(k) accounts from a selection that their employer offers. Those offerings typically include stock and bond mutual funds and target-date funds designed to reduce the risk of losses as the employee approaches retirement.

History of the 401(k)

The United States has undergone a significant shift in how Americans save for retirement, as illustrated below by our chart comparing the number of Americans (in millions) in defined benefit and defined contribution plans, along with the total for both.

Defined contribution plans, most of which are 401(k)s, are an alternative to the traditional pension, known as a defined benefit plan. With a pension, the employer is committed to providing a specific amount of money to the employee for life during retirement. In recent decades, as the chart below shows, defined contribution plans like 401(k)s have become far more common, and traditional pensions have become rare as employers have shifted the responsibility and risk of saving for retirement to employees.

Comparing the Number of Americans in Defined Benefit vs. Defined Contribution Plans

Above, the number of Americans in defined benefit and defined contribution plans, along with the total of both, in millions.

Initially offered by employers to supplement other employee benefits, 401(k)s have become the most common private employer-sponsored retirement program in the U.S. About a third of working-age Americans have a 401(k), compared with one in nine who have a defined benefit pension plan. Meanwhile, U.S. Census data suggests that as many as four in 10 baby boomers and half of millennials have no retirement account at all.

Still, the 401(k) plan was designed to encourage Americans to save for retirement. Among its benefits are tax savings. There are two main options, traditional and Roth, each with distinct tax advantages. If your employer offers both types of 401(k) plans, you can split your contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).

Traditional 401(k)s

With a traditional 401(k), employee contributions are deducted from gross income. This means the money comes from your paycheck before income taxes have been deducted.

As a result, your taxable income is reduced by the total contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until you withdraw the money, usually in retirement.

Roth 401(k)s

When 401(k) plans were first rolled out in the early 1980s, companies and their employees had one choice: the traditional 401(k). Then, in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible. At first, Roth 401(k)s caught on slowly, but now many employers offer them.

With a Roth 401(k), contributions are deducted from your after-tax income. This means you contribute from your pay after income taxes have been deducted. As a result, there is no tax deduction in the year of the contribution. When you withdraw the money during retirement, though, you don’t have to pay any additional taxes on your contribution or on the investment earnings.

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break.

Employees anticipating a higher tax bracket after retiring might choose a Roth 401(k) to avoid paying taxes on their savings later. This decision could be especially worthwhile if the Roth has many years to grow, as all the money earned by the contributions over decades will be tax free upon withdrawal.

As a practical matter, the Roth reduces your immediate spending power more than a traditional 401(k) plan. That matters if your budget is tight.

Even though contributions to a Roth 401(k) are made with after-tax money, there are, generally speaking, tax consequences if withdrawals are made before you’re 59½ years old. Always check with an accountant or qualified financial advisor before withdrawing money from either a Roth or traditional 401(k).

401(k) Plan Contribution Limits

Traditional and Roth 401(k) plans are defined contribution plans. Both the employee and employer can contribute to the account up to the dollar limits set by the Internal Revenue Service (IRS).

The maximum amount an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which measures rising prices.

For 2024, the annual limit on employee contributions to a 401(k) is $23,000 for workers under age 50. In addition, those age 50 or older can make a $7,500 catch-up contribution.

There is a limit on total employee and employer contributions for the year:

Employer Matching

• For workers under 50 years old, the combined limit for both employee and employer contributions is $69,000 per year.
• If the catch-up contribution for those 50 or older is included, the combined limit is $76,500.

Employers who match employee contributions use various formulas to calculate that match.

For instance, an employer might match $0.50 for every $1 that the employee contributes, up to a certain percentage of salary. Vanguard estimates that about four in 10 companies have 401(k) matching contributions of up to 6% of their employees’ wages. Only 10% of companies offer more than that.

Lazaroff, who also hosts the investment education podcast The Long Term Investor, said that if you can take advantage of your employer’s matching contributions, you should. It’s a risk-free way to grow your money and not leave part of your compensation on the table.

“Meeting the match doesn’t necessarily mean you have to sacrifice other financial goals, such as paying down debt or establishing an emergency fund,” he said. “You can still chip away at debt and put away small amounts in an emergency fund if necessary. But securing that employer match is crucial.”

How Does Your 401(k) Earn Money?

When you contribute to your 401(k) account, your money is invested according to your choices from the options your employer offers. These typically include an assortment of target-date funds and mutual funds.

Target-date funds are the way “you’re least likely to make mistakes,” Lazaroff said. These accounts contain a mix of stocks, bonds, and other securities that are adjusted as your chosen date approaches, generally shifting toward more conservative investments as you near retirement.

“You might be different from the average, and you might accumulate enough wealth one day where a target-date fund isn’t the most appropriate. But for many people, it’s one of the easier and least risky routes to take,” Lazaroff said.

Several factors influence the pace and extent of your 401(k)’s growth, including the amount you contribute annually, any company matches, investment performance, and the time until retirement.

A significant benefit of a 401(k) is tax-deferred growth. With a traditional 401(k), you don’t have to pay taxes on investment gains, interest, or dividends until you withdraw money from the account. However, if you have a Roth 401(k), you won’t have to pay taxes on qualified withdrawals when you retire, as contributions are made with after-tax dollars.

Opening a 401(k) also allows your money to grow over time, thanks to the power of compounding. Compounding occurs when the returns generated by your savings are reinvested into the account, generating returns of their own. Over many years, the compounded earnings in your 401(k) account can exceed the amount you contributed. This is why, as you continue to contribute to your 401(k), it can grow quite substantially by the time you retire.

401(k) Withdrawals

Once your money goes into a 401(k), it can be difficult to withdraw it without paying taxes on the amount.

“Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement,” saidDan Stewart, the head of Dallas-based Revere Asset Management. “Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary.”

Earnings in a 401(k) account are tax deferred for traditional 401(k) accounts and tax free for Roth accounts. When you withdraw from a traditional 401(k), that money (which has never been taxed) will be taxed as ordinary income. With a Roth, you’ve already paid income tax on the money you contributed, so you won’t owe taxes on withdrawals if you satisfy specific requirements.

You must be at least 59½—or meet IRS criteria for a hardship withdrawal—when you start making withdrawals, or you will face a 10% early withdrawal penalty on top of any other income tax you owe.

Required Minimum Distributions

Traditional 401(k) account holders have required minimum distributions (RMDs) after reaching a certain age. (Withdrawals are called distributions in IRS parlance.)

Investors who have retired must start taking RMDs from their 401(k) plans at age 73. The amount of the RMD is calculated based on your life expectancy at the time. Before 2020, the RMD age was 70½ years old. Before 2023, it was 72. It was updated to age 73 in the omnibus spending bill H.R. 2617 in 2022.

What Are the Pros and Cons of a 401(k)?

On the plus side, a traditional 401(k) plan lets you reduce your tax burden while saving for retirement. With a Roth 401(k), qualifying withdrawals are tax free. And not only do you get tax-deferred gains, but it’s also hassle free, because contributions are automatically subtracted from your paycheck. What’s more, your employer might provide a match, boosting your retirement savings.

However, a 401(k) can come with fees—though they’re typically modest. Traditional (not Roth) accounts are subject to RMDs. There are penalties for withdrawing funds early—if you’re younger than 59½ and you don’t qualify for a hardship withdrawal, you’ll need to pay a 10% penalty to the IRS. And a 401(k) might not be enough on its own to sustain you in retirement, depending on your goals and circ*mstances. Consider talking to a financial professional who can walk you through other options.

401(k)s vs. Brokerage Accounts

Both brokerage and 401(k) accounts are investment accounts, but they serve different purposes. A 401(k) is primarily for retirement savings, while a brokerage account can be used for various financial goals and often offers more control over the investments.

A 401(k) is a type of qualified retirement plan. Within it, you can choose from a menu of investment options (generally mutual funds) where your money grows in a tax-advantaged manner.

A brokerage account, meanwhile, is a private account where you can buy, sell, and hold whatever securities your broker has access to, including mutual funds, stocks, bonds, and exchange-traded funds (ETFs). Brokerage accounts are taxable, meaning that your capital gains and dividends are subject to tax in the current period. There are also no contribution limits, early withdrawal considerations, or minimum distributions.

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

When you leave a company where you’ve been employed and you have a 401(k) plan, you generally have four options:

1. Withdraw the Money

Withdrawing the money is usually a bad idea unless you urgently need it. The money will be taxable for the year it’s withdrawn. You will be hit with the additional 10% early distribution tax unless you are 59½ or older, permanently disabled, or meet the other IRS criteria for an exemption from the rule.

For a Roth 401(k), you can withdraw your contributions (but not any earnings) tax free and without penalty if you have had the account for at least five years or meet the IRS criteria mentioned previously. However, you’re still decreasing your retirement savings, which you may regret later.

2. Roll Your 401(k) Into an IRA

Moving the money into an individual retirement account (IRA) at a brokerage firm or a bank means avoiding immediate taxes and maintaining the account’s tax-advantaged status. What’s more, you can choose from among a wider range of investment choices than with your employer’s plan.

The IRS has relatively strict rules on rollovers and how they need to be accomplished. Running afoul of them is costly. Typically, the financial institution in line to receive the money will help with the process to prevent any missteps.

3. Leave Your 401(k) With Your Former Employer

In many cases, employers permit a departing employee to keep a 401(k) account indefinitely in their old plan, though the employee can’t contribute further. This generally applies to accounts worth at least $5,000. For smaller accounts, the employer may give the employee no choice but to move the money elsewhere.

Leaving the money where it is makes sense if the former employer’s plan is well-managed and you are satisfied with its investment choices. The danger is that employees who change jobs throughout their careers can leave a trail of old 401(k) plans and may forget about one or more of them. Their heirs might also be unaware of the existence of the accounts.

Capitalize, an investment platform specializing in rolling over forgotten or left-behind 401(k) accounts, estimates that in 2023, there were almost 30 million such accounts in the U.S., holding about a quarter of Americans’ total assets in 401(k) plans.

4. Move Your 401(k) to Your New Employer

You can usually move your 401(k) balance to your new employer’s plan. As with an IRA rollover, this maintains the account’s tax-deferred status and avoids immediate taxes.

If you aren’t comfortable with managing a rollover IRA, you can leave some of the work to the new plan’s administrator.

The Bottom Line

A 401(k) plan is a workplace retirement plan that allows you to make annual contributions up to a specific limit and invest that money for your later years after your working days are over.

There are two major types of 401(k) plans: traditional or Roth. The traditional 401(k) involves pretax contributions that give you a tax break when you make them and reduce your taxable income. However, you pay ordinary income tax on your withdrawals. The Roth 401(k) involves after-tax contributions and no upfront tax break, but you won’t pay taxes on your withdrawals in retirement. Both accounts allow employer contributions that can increase your savings.

Correction—Aug. 25, 2024: This article has been corrected to explain when Roth 401(k) contributions can be withdrawn tax-free and without penalty.