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401(k) Plan

A 401(k) plan is an employer-sponsored retirement account in which you contribute a portion of your pre-tax salary, and your employer often adds matching contributions. The money grows tax-deferred until you withdraw it, usually in retirement.

For the principle of employer matching, see 401(k) match; for vesting and earned credits, see vesting; for alternative retirement accounts, see traditional IRA, Roth IRA, and SEP IRA.

What a 401(k) is

The 401(k) gets its name from a section of the Internal Revenue Code. It allows you to contribute money to a retirement account before taxes are withheld from your paycheck. This reduces your taxable income in the current year. The money then grows, tax-free, until you withdraw it in retirement.

The employer often adds matching contributions — typically 3–6% of your salary. This is free money, and it is the single most valuable benefit most people have access to.

How it works

On payday, your employer deducts your 401(k) contribution from your gross pay before taxes are calculated. If you earn $4,000 and contribute $600 to your 401(k), your taxable income is $3,400. If your marginal tax rate is 22%, you save $132 in taxes (22% of $600).

That $600 (and any employer match) goes into your 401(k) account, which is typically invested in a menu of mutual funds or index funds offered by the plan. You choose how to allocate your balance among these options.

Employer matching

If your employer offers matching (not all do, though most large companies do), the match is usually “3% of salary” or “100% match up to 3%, 50% match from 3% to 6%.” The second formula means: contribute 3%, get 100% back; contribute 6%, get 100% on the first 3% and 50% on the next 3%, for a total employer contribution of 4.5%.

The match is not guaranteed for all time. If the company has financial difficulties, it can reduce or suspend matching. But once matched contributions are made, they are yours.

Types of 401(k) contributions

Traditional 401(k). Your contributions reduce your taxable income in the year you make them. In retirement, withdrawals are taxed as ordinary income.

Roth 401(k). Your contributions are after-tax (no tax deduction now). In retirement, withdrawals are tax-free. Some plans offer both options; many offer only traditional.

Solo 401(k). If you are self-employed, you can open your own 401(k) (solo 401k) and contribute as both employer and employee.

Contribution limits

For 2024, you can contribute up to $23,500 per year as an employee (aged under 50). If you are 50+, you can contribute an additional $7,500 (“catch-up” contributions) for a total of $31,000. Your employer’s match does not count toward this limit; the total (employee + employer) can be up to $69,000.

Investment choices

Your 401(k) plan offers a menu of investment options, typically including:

  • Target-date funds (automatically adjusted as you near retirement)
  • Index funds tracking broad markets
  • Actively managed mutual funds
  • Stable value funds (low-risk, but lower returns)
  • Company stock (if employer allows)

You choose how to allocate your balance among these options.

Withdrawal and penalties

You can withdraw your 401(k) at retirement age (59½). Withdrawals before 59½ are typically subject to a 10% penalty plus ordinary income taxes, though some exceptions exist (hardship, disability, separation from service after 55).

You must begin taking required minimum distributions (RMDs) at age 73. These are mandatory withdrawals designed to eventually deplete the account.

Leaving your job

When you leave your employer, your 401(k) balance is yours to keep. You can:

  1. Leave it with the old employer. The account stays there, continuing to grow; withdrawal rules apply when you reach retirement age.
  2. Roll it to an IRA. This moves the balance to an IRA account, which may offer more investment options.
  3. Roll it to a new employer’s 401(k). If your new job has a plan that accepts rollovers.
  4. Cash it out. This triggers immediate taxes and penalties (usually 10% penalty + ordinary income taxes for early withdrawal).

The fourth option is rarely advisable, as the tax and penalty can consume 30%+ of the balance.

Vesting

Some employers require a vesting period before employer match is fully yours. If vesting is 3 years and you leave after 2 years, you might lose 40% of the employer match. Always check your plan’s vesting schedule.

401(k) vs. other retirement accounts

A 401(k) is the employer’s solution. For self-employed people or if your employer does not offer one, alternatives include traditional IRA, Roth IRA, and SEP IRA. The biggest advantage of a 401(k) is the employer match, which is free money.

See also

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