401(k) Plan: What It Is and How It Works
To make the most of your 401(k) plan, we’ll cover how to differentiate between different 401(k) types, choose a contribution limit and select investments to help your account grow.
An overview of 401(k) plans
A 401(k) is an employer-sponsored retirement account. To contribute, employees direct a portion of every paycheck into the account. It’s common for employers to match a portion of these contributions as a workplace benefit.
How a 401(k) plan works
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Employee contributions. Employees choose a percentage of their paycheck to go into their 401(k) account. It’s deducted automatically and deposited directly into their 401(k) plan.
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Employer match. Many employers offer to match a percentage of these contributions, providing an extra boost of retirement savings.
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Investment selections. Options within a 401(k) plan can include stocks, bonds, and mutual funds, but are dependent on your plan provider. A common investment option is target-date funds, which automatically adjust their investment mix from aggressive to conservative as the account owner reaches retirement age.
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Vesting schedule. While an employee’s contributions are always theirs, their employer’s match may be subject to a vesting schedule. This means the employee might not fully own the employer contributions until after a set period of time.
The two main types of 401(k) plans
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Traditional 401(k). This type of 401(k) is funded with pretax money, which lowers an employee’s taxable income for the year. Withdrawals in retirement are taxed at the ordinary income rate, and are subject to required minimum distributions (RMDs) in retirement.
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Roth 401(k). The Roth 401(k) takes after-tax contributions, but withdrawals in retirement are tax-free. Roth 401(k)s do not have RMDs.
What else to know about 401(k) plans
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Annual contribution limits. The IRS determines how much both employees and employers can contribute to a 401(k) every year. That limit is $23,500 in 2025. People aged 50 and older can contribute an extra $7,500 as a catch-up contribution. Due to the Secure 2.0 Act, those aged 60, 61, 62 and 63 get a higher catch-up contribution of $11,250. In 2026, the contribution limit is $24,500, with a catch-up contribution of $8,000. Those aged 60, 61, 62, and 63 will have the same higher catch-up contribution of $11,250 .
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Contribution deadline. The last day to contribute to a 401(k) plan every year is December 31st for that year.
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Early withdrawal penalties. Taking out money before age 59 ½ typically incurs taxes and a 10% penalty, except in some instances.
A 401(k) plan is an employer-sponsored retirement account that allows employees to contribute a portion of their paycheck to save for retirement. Oftentimes, employers may match part of these contributions, but it is not required.
There are two main types of 401(k) plans: traditional and Roth. The traditional 401(k) is funded with pretax money, while the Roth 401(k) takes after-tax contributions. The type of plan you have determines what tax advantages you can receive, either now or during retirement.
Here’s an overview of the basics.
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When you enroll in a 401(k) plan, you’re agreeing to put a percentage of your paycheck into a retirement investment account.
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Once you invest your 401(k) money, it can grow tax-deferred, meaning you don’t pay capital gains tax on your investment profits while they’re in the account.
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Some employers match part or all of your contributions. This is free money added to your account as an employer benefit.
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When it comes time to make withdrawals in retirement, you may have to pay taxes on the money you take out, depending on the type of plan you have.
Here are some advantages and disadvantages at a glance.
Pros
The portion of your paycheck that you contribute to a traditional 401(k) isn’t subject to income tax.
No capital gains tax while money is in the account.
Some employers match employee contributions.
Higher annual contribution limit than for IRAs.
Cons
Must pay a penalty for early withdrawals.
There is an annual contribution limit.
Relatively limited selection of investments.
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Roth 401(k) |
Traditional 401(k) |
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|---|---|---|
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Contribution limits |
You can contribute to both accounts in the same year, as long as you keep your total contributions under the cap. You can contribute $23,500 in 2025. People aged 50 and older can contribute an extra $7,500 as a catch-up contribution. Due to the Secure 2.0 Act, those aged 60, 61, 62 and 63 get a higher catch-up contribution of $11,250. In 2026, the contribution limit is $24,500, with a catch-up contribution of $8,000. Those aged 60, 61, 62, and 63 will have the same higher catch-up contribution of $11,250. |
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Tax treatment of contributions |
Contributions are made after taxes, with no effect on current adjusted gross income. Employer matching dollars must go into a pretax account and are taxed when distributed. |
Contributions are made pretax, which reduces your current adjusted gross income. |
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Tax treatment of withdrawals |
No taxes on qualified distributions in retirement. |
Distributions in retirement are taxed as ordinary income. |
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Withdrawal rules |
Withdrawals of contributions and earnings are not taxed as long as the distribution is considered qualified by the IRS: The account has been held for five years or more and the distribution is: Unlike a Roth IRA, you cannot withdraw contributions any time you choose. |
Withdrawals of contributions and earnings are taxed. Distributions may be penalized if taken before age 59 ½, unless you meet one of the IRS exceptions. |
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How much can I contribute to my 401(k)?
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2025 401(k) contribution limits |
2026 401(k) contribution limits |
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|---|---|---|
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Employee contribution limit |
$23,500 |
$24,500 |
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Catch-up contribution limit for individuals age 50 and older |
$7,500 (or up to $11,250 for those ages 60 to 63). |
$8,000 (or up to $11,250 for those ages 60 to 63). |
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Maximum employee and employer contribution |
Cannot exceed the lesser of $70,000 for those under 50 ($77,500 for those 50 and up) or 100% of employee compensation. |
Cannot exceed the lesser of $72,000 or 100% of employee compensation. |
The last day to contribute to a 401(k) plan for 2025 is Dec. 31, 2025. There are no income limits restricting who can contribute to a 401(k) plan.
401(k) contribution limits
If 10% to 15% of your salary feels too steep, it’s fine to contribute what you can and work your way up as you can afford to. You aren’t required to contribute the maximum, but it’s a good rule of thumb to consider contributing enough to get your employer match if one is offered.
What are the 401(k) withdrawal rules?
Still, in most cases, an early 401(k) withdrawal will trigger taxes and leave less money in the account to invest over time.
What are required minimum distributions?
Frequently asked questions
What happens to my 401(k) if I quit my job?
Can I lose money in a 401(k)?
Yes, you can lose money in a 401(k) plan. Because the money is invested, there is always a risk of loss based on economic changes, financial market movements or other factors.
How long does it take for my 401(k) to vest?
That depends on your plan’s rules. Your contributions are always yours. Your employer’s contributions, on the other hand, may vest immediately or on a fixed schedule. The best way to find out is to check with your human resources team or directly with your employer plan provider.
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