401(k) Plan

What is a 401(k)?

A 401(k) is an employer-sponsored, tax-advantaged retirement savings plan named for a section of the U.S. tax code. It’s a defined-contribution account: employees (and often employers) put money into an investment account, and retirement income depends on the accumulated contributions and investment returns.

There are two primary types:
– Traditional 401(k): Contributions are made pretax and reduce taxable income today; withdrawals in retirement are taxed as ordinary income.
– Roth 401(k): Contributions are made with after-tax dollars; qualified withdrawals in retirement are tax-free.

How 401(k)s work

• Payroll contributions: You elect a percentage or dollar amount to be deducted from each paycheck and invested.
• Investment menu: Employers provide a limited selection of investments—commonly mutual funds, target-date funds, and sometimes the employer’s stock or guaranteed contracts.
• Employer contributions: Many employers match a portion of employee contributions according to a formula (for example, $0.50 per $1 up to a salary percentage).
• Tax advantages: Traditional plans allow tax-deferred growth; Roth plans allow tax-free qualified withdrawals.

Starting a 401(k)

1. Ask your employer whether a 401(k) is offered and whether there’s a match.
2. Enroll following your employer’s procedures.
3. Choose investments from the plan’s options—target-date funds are a common, low-maintenance choice.
4. If you’re self-employed, consider a solo (one-participant) 401(k) through a broker.

Contribution limits (2025)

• Employee deferral limit: $23,500 for those under 50.
• Catch-up contribution: Additional $7,500 for those 50 or older (totaling $31,000 for age 50+).
• Combined employee + employer limit: $70,000 for employees under 50; $77,500 including catch-up contributions for those 50+.

These limits are adjusted periodically for inflation.

Employer matching

Employer matches vary by plan (common formulas include partial matches up to a percentage of salary). Taking full advantage of any employer match is generally recommended because it’s effectively free compensation that boosts retirement savings.

How your 401(k) earns money

Your contributions are invested according to your choices. Growth comes from capital appreciation, dividends, and interest. Key drivers of long-term results include:
– Contribution size and consistency
– Employer matching
– Investment performance
– Time horizon and compounding

Target-date funds provide an automated asset allocation that becomes more conservative as retirement nears, which can reduce the risk of poor allocation decisions.

Withdrawals and penalties

• Normal withdrawals: For traditional 401(k)s, withdrawals are taxed as ordinary income. Roth 401(k) qualified withdrawals are tax-free.
• Early withdrawals: Withdrawals before age 59½ typically incur a 10% penalty plus taxes, unless an IRS exception applies (certain hardship rules, disability, etc.).
• Loans: Some plans permit loans against your balance, which must be repaid under plan rules.

Required Minimum Distributions (RMDs)

Traditional 401(k) accounts require minimum distributions once you reach the IRS-specified age (age 73 as currently legislated for many retirees). The RMD amount is based on life expectancy and account balance; failing to take an RMD can trigger penalties.

Pros and cons

Pros
– Tax-advantaged growth (deferred or tax-free)
– Automatic payroll contributions
– Potential employer match
– Wide adoption by employers

Cons
– Limited investment choices compared with taxable brokerage accounts
– Early withdrawal penalties and RMD rules (for traditional 401(k)s)
– Plan fees can reduce returns
– May not be sufficient alone to fund retirement; other savings vehicles are often needed

Many investors split contributions between traditional and Roth accounts to diversify future tax exposure.

History in brief

Over recent decades, the U.S. has shifted from employer-funded defined-benefit pensions to defined-contribution plans like 401(k)s. This transfer of retirement saving responsibility from employers to employees made 401(k)s the most common private employer retirement vehicle.

401(k) vs. brokerage account

• Purpose: 401(k) = retirement; brokerage = any financial goal.
• Sponsorship: 401(k) is employer-sponsored; brokerage is individual.
• Investment choices: 401(k) has a plan menu; brokerage accounts offer broader access (stocks, ETFs, bonds, etc.).
• Taxes: 401(k) grows tax-advantaged; brokerage accounts are taxable (capital gains and dividends).
• Rules: 401(k)s have contribution limits, early-withdrawal penalties, and RMDs; brokerage accounts have none of those constraints but lack employer matching.

When you leave a job: four common options

1. Withdraw the money — usually unwise because of taxes, penalties, and reduced retirement savings.
2. Roll over to an IRA — preserves tax-advantaged status and typically expands investment choices. Follow rollover rules carefully to avoid taxes (60-day rollover deadline for indirect rollovers).
3. Leave the money in the former employer’s plan — allowed in many plans if your balance meets the plan’s minimum; can be fine if the plan is well-managed.
4. Move the balance to your new employer’s plan — keeps funds consolidated and tax-advantaged if the new plan accepts rollovers.

Frequently asked questions

What is the maximum contribution to a 401(k)?
– For 2025: $23,500 deferral limit for under 50; $7,500 catch-up for those 50+ (total $31,000). Combined employee + employer contributions are capped at $70,000 ($77,500 including catch-up).

Is it a good idea to take early withdrawals?
– Generally no. Early withdrawals often incur a 10% penalty plus taxes and reduce long-term retirement savings. Hardship exceptions exist but still may trigger taxes or other consequences.

How should I respond to a stock sell-off?
– For long-term retirement investors, the common advice is to stay the course. Market downturns can be unsettling, but they are also when long-term investors buy assets at lower prices. Revisit your asset allocation if your risk tolerance or time horizon has changed.

Bottom line

A 401(k) is a central retirement savings tool for many workers, offering tax advantages and possible employer matching. Choosing between traditional and Roth contributions depends on whether you prefer tax savings today or tax-free income later. Maximize employer matching, invest consistently, and treat rollovers and withdrawals carefully to preserve tax benefits and grow your retirement nest egg.