401(k) Basics: Everything You Need to Know

A 401(k) is the most powerful retirement savings tool most Americans have access to, and yet a surprising number of people either don't use it or don't fully understand how it works. If your employer offers one, you've got a serious advantage. Let's break down exactly what a 401(k) is, how it works, and how to make the most of yours.

What Is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan. It lets you set aside a portion of your paycheck before taxes (or after taxes, if you choose the Roth option) and invest it for retirement. The money grows tax-deferred, meaning you don't pay taxes on the gains each year. You'll pay taxes when you withdraw the money in retirement.

The name "401(k)" comes from the section of the tax code that created it. Not the catchiest branding, but the tax benefits more than make up for it.

2025 Contribution Limits

The IRS sets annual limits on how much you can contribute. For 2025, the numbers are:

• Employee contribution limit: $23,500 (up from $23,000 in 2024)
• Catch-up contributions (age 50+): An additional $7,500, for a total of $31,000
• Total limit (employee + employer): $70,000

These limits apply across all your 401(k) accounts. If you have two jobs with two 401(k) plans, your combined employee contributions can't exceed $23,500 (or $31,000 if you're 50+).

Pre-Tax vs. Roth 401(k)

Many employers now offer both traditional (pre-tax) and Roth 401(k) options. Here's the key difference:

Pre-Tax (Traditional) 401(k)

Contributions come out of your paycheck before income taxes are calculated. This lowers your taxable income today. If you earn $80,000 and contribute $10,000 to a pre-tax 401(k), you're only taxed on $70,000. The trade-off? You'll pay income taxes on every dollar you withdraw in retirement.

Roth 401(k)

Contributions come from after-tax dollars. You don't get a tax break today, but your withdrawals in retirement are completely tax-free, including all the investment growth. If your $10,000 contribution grows to $50,000 over 30 years, you pay zero taxes on that $50,000 when you withdraw it.

Which Should You Choose?

The general guidance is:

• Choose pre-tax if you're in a high tax bracket now and expect to be in a lower bracket in retirement.
• Choose Roth if you're in a lower tax bracket now (early in your career, lower income) and expect to be in a higher bracket later.
• Split it if you're not sure. Having both pre-tax and Roth money gives you flexibility in retirement to manage your tax bill.

Nobody knows what tax rates will look like in 20 or 30 years. Diversifying across pre-tax and Roth accounts hedges your bets.

Employer Matching: Free Money

Many employers match a portion of your 401(k) contributions. A common formula is "50% match on the first 6% of salary." That means if you earn $80,000 and contribute 6% ($4,800), your employer kicks in another $2,400. That's a guaranteed 50% return on your money before it even gets invested.

The single most important rule of 401(k) investing is this: always contribute at least enough to get the full employer match. Not doing so is literally turning down free compensation.

Employer matching contributions are always pre-tax, regardless of whether your own contributions are pre-tax or Roth. They go into a separate pre-tax bucket in your account.

Vesting Schedules

Your own contributions are always 100% yours. But employer matching contributions often come with a vesting schedule, which determines how much of the employer's money you get to keep if you leave the company.

There are two common vesting types:

Cliff Vesting

You're 0% vested until a specific date (usually 3 years of service), then you become 100% vested all at once. Leave before the cliff, and you forfeit all employer contributions.

Graded Vesting

You gradually become more vested over time. A typical graded schedule might look like this:

• Year 1: 0% vested
• Year 2: 20% vested
• Year 3: 40% vested
• Year 4: 60% vested
• Year 5: 80% vested
• Year 6: 100% vested

Vesting is something to pay attention to when considering a job change. If you're close to a vesting milestone, it might be worth sticking around a few more months to secure those employer contributions.

Investment Options

Unlike a brokerage account where you can buy any stock or fund, 401(k) plans offer a limited menu of investment options chosen by your employer. Typically you'll see:

• Target-date funds: Pick the fund closest to your expected retirement year (like "Target 2055") and it automatically adjusts from stocks to bonds as you age. These are great for people who don't want to manage their own investments.
• Index funds: Low-cost funds that track a market index like the S&P 500. Look for expense ratios under 0.10%.
• Bond funds: Lower risk, lower return. More appropriate as you get closer to retirement.
• Company stock: Some employers offer their own stock as an option. Be cautious here. You don't want too much of your retirement tied to one company.

The most important thing with investment selection is keeping costs low. A fund with a 1% expense ratio will eat tens of thousands of dollars over a career compared to a 0.05% index fund.

Try the Calculator

See how your 401(k) contributions could grow over time. Adjust your salary, contribution rate, employer match, and expected returns to model different scenarios.

When Can You Withdraw?

The standard rule is that you can start withdrawing from your 401(k) penalty-free at age 59 and a half. Withdraw earlier, and you'll typically face a 10% early withdrawal penalty plus income taxes on the amount.

There are some exceptions:

• Rule of 55: If you leave your employer in or after the year you turn 55, you can withdraw from that employer's 401(k) without the 10% penalty.
• Hardship withdrawals: Some plans allow withdrawals for specific emergencies, but you'll still owe taxes and usually the penalty.
• 401(k) loans: Many plans let you borrow against your balance. You pay yourself back with interest, but if you leave your job, the loan typically comes due immediately.

Required Minimum Distributions (RMDs) kick in at age 73. At that point, you must start withdrawing a minimum amount each year, whether you need the money or not. Roth 401(k) accounts are also subject to RMDs, though you can avoid this by rolling your Roth 401(k) into a Roth IRA.

Common 401(k) Mistakes

1. Not enrolling at all. Some employers auto-enroll you at a low rate (like 3%), but others require you to opt in. Don't leave money on the table.
2. Contributing less than the match. If your employer matches up to 6% and you're only contributing 3%, you're giving up half the free money.
3. Never increasing your contribution rate. Start at whatever you can afford, then bump it up by 1% each year.
4. Cashing out when you change jobs. Rolling your 401(k) into your new employer's plan or an IRA preserves the tax advantages. Cashing out triggers taxes and penalties.
5. Ignoring fees. High expense ratios silently drain your returns. Always check what you're paying.

The Bottom Line

A 401(k) is one of the best wealth-building tools available to working Americans. The tax advantages, employer match, and automatic payroll deductions make it easier to save consistently. If you do nothing else for your retirement, contribute enough to get your full employer match. From there, try to increase your contribution rate each year until you're saving 15% or more of your income. Your future self will thank you.