A 401(k) is a retirement savings account sponsored by your employer. You contribute a portion of your paycheck before taxes, the money grows tax-deferred, and you pay income tax only when you withdraw in retirement. If your employer offers a match, it’s the closest thing to free money in personal finance.
Most people have access to one. Most people don’t use it effectively. Here’s what you actually need to know.
How a 401(k) works
When you enroll, you choose a contribution percentage — say, 6% of your salary. That percentage is deducted from each paycheck before federal income taxes are calculated. If you earn $5,000/month and contribute 6%, your taxable income drops to $4,700. At a 22% tax bracket, that’s $66 less in taxes each month — your real cost of contributing $300 is $234.
The money goes into your 401(k) account and is invested in whatever funds you select from the plan’s menu. It grows without being taxed each year — no tax on dividends, no capital gains tax when you rebalance. Tax is owed when you withdraw the money, presumably in retirement when your income (and tax rate) is lower.
The 2026 contribution limits
- Employee contribution limit: $23,500/year
- Catch-up contribution (age 50+): Additional $7,500/year ($31,000 total)
- Super catch-up (age 60–63): Additional $11,250/year under SECURE 2.0 rules
- Total limit including employer contributions: $70,000/year
Most people don’t hit $23,500 — the median 401(k) contribution is around $6,000–8,000/year. That’s fine. Start with whatever you can, increase by 1% each year.
The employer match: never leave this on the table
Most employers match a portion of your contribution — commonly 50% of contributions up to 6% of salary, or 100% match up to 3-4%. This match is additional compensation that disappears if you don’t contribute enough to capture it.
Example: You earn $70,000. Your employer matches 100% of contributions up to 4% of salary ($2,800). If you contribute 4% ($2,800), your employer adds $2,800. You’ve earned a 100% instant return on $2,800.
The first goal of any 401(k) strategy is to contribute at least enough to get the full employer match. Everything else — Roth IRA, HSA, taxable brokerage — comes after this.
Traditional 401(k) vs. Roth 401(k)
Most plans now offer both. The difference is when you pay taxes:
Traditional 401(k): Contributions are pre-tax (reduce your taxable income now). Withdrawals in retirement are taxed as ordinary income.
Roth 401(k): Contributions are after-tax (no immediate tax break). Withdrawals in retirement are tax-free, including all growth.
Which to choose: If you’re early in your career and expect your income (and tax rate) to be higher in retirement, Roth makes sense. If you’re in your peak earning years and want the tax break now, traditional is usually better. Many people split contributions between both — a hedge on future tax rates.
Unlike a Roth IRA, a Roth 401(k) has no income limit. High earners who can’t contribute to a Roth IRA directly can still use a Roth 401(k).
What to do with the investment options
Most 401(k) plans offer a limited menu of 10–30 funds. The right approach for most people:
Option A — Target-date fund: Pick the fund with the year closest to when you’ll turn 65 (e.g., “Target Date 2055 Fund” if you’re 34 now). It holds a diversified mix of stocks and bonds that automatically shifts more conservative as the date approaches. Zero decisions required. Learn more about target-date funds.
Option B — Build your own: Look for a US total market index fund and an international index fund. Allocate based on your target allocation (e.g., 60% US, 30% international, 10% bonds). Rebalance once per year.
Avoid: Actively managed funds with expense ratios above 0.5%. A fund charging 1% annually costs you roughly 20% of your ending balance over 30 years compared to a 0.05% index fund — before taxes.
Vesting: when the employer match is actually yours
Your contributions are always 100% yours immediately. The employer match may be subject to a vesting schedule — meaning you need to stay employed for a certain period before the match is fully yours.
Cliff vesting: You own 0% until you reach a specific date (e.g., 3 years), then 100%.
Graded vesting: You earn ownership gradually (e.g., 20%/year for 5 years).
If you’re considering leaving a job, check your vesting date. Leaving before you’re fully vested means leaving money behind.
When you can take money out
At 59½ or older: Withdrawals taxed as ordinary income, no penalty.
Before 59½: Taxed as ordinary income plus a 10% early withdrawal penalty. Exceptions exist for certain hardships, disability, and substantially equal periodic payments (SEPP).
Required minimum distributions (RMDs): Starting at age 73 (under current law), you must withdraw a minimum amount annually. Roth 401(k)s are also subject to RMDs unless rolled to a Roth IRA.
What happens when you change jobs
You have four options for an old 401(k):
- Leave it in the old plan (fine if the investment options are good and fees are low)
- Roll it to your new employer’s plan (consolidates accounts, simple)
- Roll it to an IRA (most flexibility, widest fund selection — usually the best option)
- Cash it out (triggers income tax plus 10% penalty if under 59½ — almost never the right move)
Rolling to an IRA is typically best. Do a direct rollover (plan to plan) — never take the check yourself, or 20% will be withheld for taxes.
FAQ
How much should I contribute to my 401(k)?
At minimum: enough to get the full employer match. Ideal target: 15% of gross income including employer match. If 15% feels impossible now, start at the match threshold and increase by 1% per year with each raise.
Can I contribute to a 401(k) and an IRA in the same year?
Yes. 401(k) and IRA limits are separate. Contributing the max to your 401(k) doesn’t affect your IRA limit. Priority order: 401(k) to match → Roth IRA → back to 401(k) → HSA.
What if my employer doesn’t offer a 401(k)?
If self-employed, you can open a Solo 401(k) or SEP-IRA. If you’re an employee without access to a workplace plan, an IRA (traditional or Roth) is your primary tax-advantaged option.
Is a 401(k) safe if my employer goes bankrupt?
Yes. Your 401(k) assets are held in a trust separate from the employer’s assets. An employer bankruptcy cannot seize your 401(k) balance.