How 401(k) Plans Work
A 401(k) is a retirement savings plan sponsored by your employer. Money is automatically deducted from your paycheck and invested in funds you choose from the plan's options.
The name "401(k)" comes from the section of the tax code that created it. Not glamorous, but the benefits are:
- ✓Tax advantages - Pre-tax contributions or tax-free growth (Roth). Learn more in our Tax-Advantaged Accounts lesson.
- ✓Employer matching - Free money added to your account
- ✓Automatic saving - Deducted before you can spend it
- ✓High limits - $23,000/year vs $7,000 for IRAs
Employer Matching: Free Money
This is the most important concept in retirement planning: employer matching is free money.
Here's how it typically works:
Example: "50% match up to 6%"
If you earn $60,000 and contribute 6% ($3,600/year), your employer adds 50% of that ($1,800).
That's a 50% instant return before any market growth. Where else can you get that?
| You Contribute | Employer Adds | Total Investment | Free Money |
|---|---|---|---|
| 3% ($1,800) | $900 | $2,700 | Leaving $900 on table |
| 6% ($3,600) | $1,800 | $5,400 | Max match ✓ |
| 10% ($6,000) | $1,800 | $7,800 | No additional match |
Key insight: Contributing less than 6% means leaving free money on the table. Contributing more than 6% is great, but doesn't get additional matching. Know your plan's matching formula.
What's Vesting? (Important for Job Changers)
Your contributions are always 100% yours. But employer matching contributions might have a vesting schedule — you only keep the match if you stay long enough.
Cliff Vesting (Common)
0% until Year 3, then 100%. Leave before 3 years = lose all employer match.
Graded Vesting (Gradual)
20% per year: 20% at Year 1, 40% at Year 2, ... 100% at Year 5.
Immediate Vesting (Best)
100% yours from day one. Less common but some companies offer this.
Why it matters: If you're thinking of changing jobs, check your vesting schedule in your 401(k) summary. Staying a few extra months could mean keeping thousands in employer match.
Traditional vs Roth 401(k)
Many employers offer both options. The difference is when you pay taxes:
Traditional 401(k)
- • Contributions reduce your taxable income now
- • Pay taxes when you withdraw in retirement
- • Good if you expect lower taxes in retirement
- • More money invested upfront (pre-tax)
Roth 401(k)
- • Contributions made with after-tax money
- • Withdrawals in retirement are tax-free
- • Good if you expect higher taxes in retirement
- • Popular choice for younger workers
Not sure? Many people split 50/50 between Traditional and Roth. This provides tax diversification - some money taxed now, some taxed later.
2024 Contribution Limits
Limits shown are for 2024 and change annually. Verify current limits at irs.gov before making contribution decisions.
Investment Options in a 401(k)
Unlike an IRA where you can buy almost any investment, 401(k)s limit you to funds chosen by your employer. Common options include:
- Target-date funds - "Set it and forget it" funds that adjust as you age
- Index funds - Low-cost funds tracking the S&P 500 or total market
- Bond funds - Less risky, lower returns
- Company stock - Avoid putting too much here (concentration risk)
Pro tip: Look for the lowest-cost index fund available. A fund with 0.05% fees vs 1% fees can mean tens of thousands more over your career.
What Happens When You Leave Your Job
Your 401(k) money is yours. When you leave, you have four options:
1. Leave it (if balance is over $5,000)
Keep it with your old employer. Simple, but you can't contribute anymore.
2. Roll into new employer's 401(k)
Consolidate with your new job's plan. Good for simplicity.
3. Roll into an IRA (often best)
More investment options, often lower fees. Most flexible choice.
4. Cash out (avoid this!)
You'll pay income taxes plus a 10% penalty. A $50,000 balance could become $30,000.
Now let's explore IRAs - the retirement accounts you open yourself, with even more flexibility than a 401(k).