What is a 401(k)?

It’s a tax-advantaged retirement plan in which employers may match employee contributions

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It’s never too early to start saving for retirement. And because 401(k) contributions are deducted from your paycheck, they can help you consistently save for retirement over time without even having to think about it. Some plans even offer free money in the form of an employer match.

Key insights

  • A 401(k) is a tax-advantaged retirement savings plan that often comes with an employer contribution match.
  • Traditional 401(k)s have tax benefits in the year you invest the funds; Roth 401(k)s have tax benefits in the year you take a withdrawal.
  • There are several types of 401(k) plans, even those for self-employed people. Each has its own tax rules, eligibility requirements and contribution limits.
  • Early withdrawals can have significant penalties unless you qualify for a specific hardship.

How does a 401(k) work?

A 401(k) is a retirement savings plan that’s usually offered by employers and comes with significant tax benefits. Because of these tax benefits, there are limits to how much you can contribute. For those under 50, the annual contribution limit for 2023 is $22,500. For those 50 and older, the limit is $30,000.

When you start working at a new company, you typically decide what portion of your income you want to put into your 401(k). These contributions are taken directly from your paycheck and invested on your behalf, so you don’t need to do it yourself. Depending on the type of 401(k) you choose, you’ll either receive tax benefits when you deposit the money or when you withdraw it.

Some employers also have a matching program, which means they give you extra money for contributing to your 401(k). For instance, say a company offers a 3% salary match for your 401(k) contributions. If you earn $100,000 and contribute 6% of your salary, you'll put in $6,000. Your employer's 3% match will add an extra $3,000, making your total contribution $9,000.

Do employers always match employee contributions?

While many do, not all employers match employee contributions. To find out more about your company’s 401(k) plan, reach out to your human resources department. It can tell you what kinds of retirement plans are available and if your company offers a matching program.

Types of 401(k) plans

The downside to a 401(k) is that your investment options can be limited, and not all employers offer a 401(k). There are a few types of retirement savings plans, including:

  • Traditional 401(k)
  • Roth 401(k)
  • Solo 401(k) for self-employed individuals
  • 403(b) for employees of public schools and certain tax-exempt organizations
  • 457(b) for employees of certain state and local governments and tax-exempt nongovernmental entities

Unless you fall under one of the more specialized categories, you’ve probably mostly heard about traditional and Roth 401(k)s. Some companies offer only traditional 401(k)s, some only offer Roth 401(k)s, and others offer both.

Traditional 401(k)s
Traditional 401(k)s work by taking a percentage of your paycheck out before taxes, funding the account with pretax dollars. This allows you to save for retirement and lowers your taxable income.

Say you make $50,000 a year and you contribute 3% of your income to a traditional 401(k). Since $1,500 is taken out of your salary and put into a 401(k), you’ll be taxed only on $48,500, which can help lower your tax bill.

The money in your traditional 401(k) grows tax-deferred. This means the IRS won’t tax your contributions or growth until you begin payouts in retirement. Even then, you’ll pay taxes only on the money you withdraw.

Roth 401(k)s
A Roth 401(k) allows you to make contributions to your 401(k) account with after-tax dollars. Similar to a traditional 401(k), as long as the money remains in your account, you don’t pay taxes on the investment growth. When you begin taking distributions after retirement, they’re tax-free since you’ve already paid the tax upfront.

Unlike Roth IRAs (which are different from Roth 401(k)s), there are no income limits on a Roth 401(k). So, you can contribute even if you’re a high earner. The 2023 contribution limit is $22,500. But the downside is that not all employers offer this kind of account.

If you’re young and know you’ll likely be in a higher tax bracket come retirement, it may be smart to use a Roth 401(k) and pay those taxes upfront. But if your employer offers a great matching program, it may make more sense to invest your money in a traditional 401(k) so you defer taxes on that money until retirement.

» MORE: Invest or pay off debt? Why you should do both

401(k) contribution limit 2023

There are limits to how much you and your employer can contribute to your 401(k) plan in a year.

  • The employee contribution limit for a Roth or traditional 401(k) in 2023 is $22,500. If you’re at least 50, you can make catch-up contributions of up to $7,500 as of 2023. These limits do not include your employer contributions.
  • The overall contribution limit for a 401(k) is $66,000 for 2023 or $73,500 for catch-up contributions. This limit includes your employee contributions, as well as employer matching contributions, employer nonelective contributions and allocations of forfeitures.

The deadline for making 401(k) contributions is the end of the calendar year (Dec. 31).

401(k) contribution example

Let’s say you decide to contribute 5% of your $200,000 salary to your traditional 401(k). That means you’ll contribute $10,000 that year. If your employer offers a 2% match, they’ll contribute $4,000. That means your total contribution to the 401(k) will be $14,000.

However, if you wanted to contribute more, you could contribute up to $12,500 more, as your employer contributions don’t count toward your maximum contribution limit. If you’re over 50 and catch-up contributions are available, you could contribute up to an additional $20,000.

How much should I contribute to my 401(k)?

How much you should contribute to your 401(k) depends on a variety of factors, like your income, future tax bracket and financial goals.

“For individuals who work for an employer offering a 401(k) match, it’s highly advantageous to contribute at least enough to gain the full match,” said Michelle Delker, CEO at The William Stanley CFO Group. “It’s essentially free money that also holds tax advantages.”

» MORE: How much do I need to retire?

401(k) withdrawals

Most 401(k) plans require you to start taking distributions after you reach the age of 72, regardless of whether you’re still employed. By 2033, the required minimum distribution age will be 75.

While the money in your 401(k) is usually yours (some employers have a vesting schedule for their contributions), it’s advantageous to wait until you’re at least 59½ before making withdrawals. Otherwise, you will face an early withdrawal penalty of 10%, plus you’ll have to pay up on your taxes. While there are some exceptions, they’re normally reserved for extreme or special situations.

401(k) hardship withdrawal
Under most circumstances, it’s not possible to take a penalty-free withdrawal from your 401(k) until age 59½. However, there are some situations in which an early withdrawal is permitted without penalty, including paying for:
  • Postsecondary education for you or a family member
  • Family medical or funeral expense
  • A primary residence
  • Repairs on a primary residence

You can also make a hardship withdrawal to prevent an eviction or foreclosure on your primary residence. Starting in 2024, you can make a hardship withdrawal of up to $1,000 for emergency expenses.

401(k) Rule of 55
The Rule of 55 allows individuals who are 55 or older and who have left their job to withdraw money from their 401(k) without the usual 10% early withdrawal penalty, though income tax still applies.

This rule applies only to the 401(k) associated with the most recent job you've left, not any 401(k)s from previous employers or other types of retirement accounts.

Also, you must leave your job in or after the calendar year in which you turn 55. If you retire before the year you turn 55, the 10% premature distribution applies until age 59½. Qualified public safety employees get an extra five years and can take penalty-free distributions starting at age 50.

Loan from 401(k)
If you have a 401(k), you can borrow up to 50% of the total funds or up to $50,000 (whichever is less). Normally, you pay the loan back in five years, with interest. You don’t have to pay taxes or penalties if you pay it back on time, and the interest goes back into your account.

If you leave your job after taking out a 401(k) loan, you may have to pay the loan back in full in a shorter period of time. If you default on the loan, you will be responsible for a 10% early withdrawal penalty, plus taxes.

» MORE: Using your 401(k) to pay off debt: What are your options?

401(k) vs. IRA

There are four main differences between an IRA and a 401(k): the annual contribution limits, eligibility, the required minimum distributions and the investment choices.

  • Annual contribution limits: In 2023, you can contribute $22,500 per year to a 401(k) if you’re under 50 and $30,000 if you’re 50 and older. Traditional and Roth IRAs allow you to contribute only $6,500 a year if you’re under 50, and $7,500 a year if you’re 50 and older.
  • Eligibility:
    • 401(k)s have the strictest eligibility requirements; you can enroll only if it’s offered by your employer.
    • Roth IRAs have the second strictest requirements. If you earn over $153,000 as a single individual or head of your household, or over $228,000 as a married couple filing jointly, you’re not eligible for a Roth IRA.
    • Anyone can contribute to a traditional IRA as long as they have earned income. There is no income limit.
  • Required minimum distributions: With a Roth IRA, you don’t have to take required minimum distributions (RMDs) because you’ve already paid taxes on your money. But with a traditional IRA, a traditional 401(k) and a Roth 401(k), you’re required to begin taking distributions at age 72. Your minimum payment amount is calculated based on your life expectancy and account balance.
  • Investment choices: Given that traditional and Roth IRAs are completely controlled by you, the individual, they may have more flexible investment choices compared to a 401(k).

» MORE: Can you borrow from an IRA?

Average 401(k) balance by age

The amount of savings you’ll need to fund your dream retirement depends on your goals and personal tastes. Someone who plans to retire in a destination with a lower cost of living, for example, would need less than someone who wants to stay in a high-priced city.

However, it can be helpful to see where you are in your savings targets compared to other Americans in your age group. According to Annuity.org, the average 401(k) savings by age ranges from roughly $6,000 for those just starting their savings at age 25, to about $280,000 for those 65 or older.

» MORE: Best and worst cities for retirement

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Why is it called a 401(k)?

A 401(k) gets its name from tax code subsection 401(k). This is the subsection that establishes this type of savings retirement plan and lays out the rules for it.

What is a vesting period?

A vesting period is the amount of time that passes before your employer contributions belong 100% to you. While the money you contribute is always yours, some companies may have a time requirement before your 401(k) employer match is considered yours and can follow you to your next job or into retirement.

It’s possible to be partially vested, which happens when you receive a percentage of your employer contributions based on how long you’ve been with the company when you left.

What happens to your 401(k) when you leave a job?

When you change jobs, you can no longer contribute to your employer’s retirement plan. You may forfeit some or all of your employer 401(k) match if the 401(k) has a vesting period. You can move the funds that are yours to your current employer’s plan, an IRA, cash out (potentially with penalties) or leave it in your former employer’s plan. It’s generally recommended to roll it into an IRA.

How do I find my 401(k) from an old job?

If you need to find a 401(k) from an old job, consider reaching out to your old employer, finding the information through the Labor Department or searching a database for unclaimed assets. You can also use platforms like Capitalize to find your old 401(k)s.

What is a 403(b)?

403(b)s are retirement plans that are generally available to public schools, state colleges, religious organizations, nonprofits and other tax-exempt entities. They usually have similar contribution limits and investment opportunities as 401(k)s.

What is a 457(b)?

A 457(b) is a retirement plan available to employees of local governments, like teachers or firefighters. This type of retirement plan also has similar contribution limits and investment opportunities to a 401(k).

What is a solo 401(k)?

A solo 401(k) is a savings retirement account for self-employed individuals with no employees. The contribution limits for a solo 401(k) are much higher and can go up to $66,000 in some cases (for 2023). This is because you can make both employee and employer contributions to a solo 401(k).

Bottom line

401(k)s are powerful retirement savings tools with tax advantages for those who enroll and contribute to their account. Some employers even sweeten the deal and offer a contribution matching program. Yet, not all 401(k)s are the same.

It’s essential to know your specific 401(k)’s eligibility requirements, contribution limits, withdrawal penalties and investment options.

Article sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. Specific sources for this article include:
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  7. IRS, “ 401(k) Resource Guide - Plan Participants - General Distribution Rules .” Accessed Sept. 12, 2023.
  8. IRS, “ Retirement Topics - Exceptions to Tax on Early Distributions .” Accessed Sept. 12, 2023.
  9. United States Senate Committee on Finance, “ SECURE 2.0 Act of 2022 .” Accessed Sept. 12, 2023.
  10. IRS, “ Retirement Plans FAQs regarding Loans .” Accessed Sept. 12, 2023.
  11. IRS, “ Retirement Topics - IRA Contribution Limits .” Accessed Sept. 12, 2023.
  12. IRS, “ Retirement Plan and IRA Required Minimum Distributions FAQs .” Accessed Sept. 18, 2023.
  13. IRS, “ IRS announces changes to retirement plans for 2022 .” Accessed Sept. 12, 2023.
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  17. National Registry of Unclaimed Retirement Benefits, “ About Us .” Accessed Sept. 12, 2023.
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