What Is a 401(k)? A Complete Guide to Retirement Savings

A 401(k) might be your most powerful tool for building retirement wealth—and you may already have access to one. According to the Bureau of Labor Statistics, 70% of private industry workers have access to defined contribution retirement plans like 401(k)s in 2025. Yet many workers don't fully understand how these accounts work or how to maximize their benefits.

Named after Section 401(k) of the Internal Revenue Code, a 401(k) is an employer-sponsored retirement account that offers significant tax advantages. Understanding how compound interest works over decades makes clear why starting early matters so much—your earnings generate their own earnings, creating exponential growth over time. Whether you're just starting your career or approaching retirement, understanding your 401(k) can help you build the financial security you need for the future.

How Does a 401(k) Work?

A 401(k) allows you to contribute a portion of your paycheck directly into a retirement investment account before you even see the money. According to the IRS, these "elective salary deferrals" are excluded from your taxable income, meaning you pay less in taxes today while your money grows tax-deferred until retirement.

Here's the basic process:

1. You enroll through your employer's HR department or benefits portal
2. You choose a contribution percentage (e.g., 6% of your salary)
3. Money is automatically deducted from each paycheck
4. You select investments from options your employer provides
5. Your money grows tax-deferred until you withdraw it in retirement

Most employers offer a selection of investment options including stock mutual funds, bond funds, and target-date funds that automatically adjust their asset mix as you approach retirement.

Tax-Deferred Growth Explained

When your 401(k) investments earn returns—whether from dividends, interest, or capital gains—you don't pay taxes on those earnings each year. This allows your money to compound faster than it would in a regular taxable investment account.

The taxes are deferred—not eliminated. You'll pay ordinary income tax when you withdraw funds in retirement.

Traditional vs. Roth 401(k): What's the Difference?

Many employers now offer both traditional and Roth 401(k) options. Understanding the difference can help you choose the right approach for your situation.

Traditional 401(k)

With a traditional 401(k), your contributions come from your pre-tax income. This reduces your taxable income today, giving you an immediate tax break. However, you'll pay income taxes when you withdraw funds in retirement.

Best for: People who expect to be in a lower tax bracket in retirement than they are now.

Roth 401(k)

A Roth 401(k) works in reverse. You contribute after-tax dollars, so you don't get a tax break today. But your withdrawals in retirement—including all the investment growth—are completely tax-free.

Best for: People who expect to be in a higher tax bracket in retirement, or who want tax diversification.

401(k) Contribution Limits for 2025 and 2026

The IRS sets annual limits on how much you can contribute to your 401(k). These limits typically increase each year to account for inflation.

Employee Contribution Limits

Total Contribution Limits (Employee + Employer)

When you combine your contributions with your employer's matching contributions, there's a higher overall limit:

These higher limits matter if you have a generous employer match or make additional after-tax contributions (if your plan allows them).

Understanding Employer Matching

Employer matching is often called "free money"—and for good reason. When your employer matches your 401(k) contributions, they're essentially giving you extra compensation for saving for retirement.

Common Matching Formulas

Employers use various matching formulas. Here are the most common:

According to research cited by Investopedia, about 13% of companies match 50 cents per dollar on up to 6% of employee contributions—a common formula in American workplaces.

Vesting Schedules

While your own contributions are always 100% yours, employer matching contributions may be subject to a vesting schedule. This means you might not "own" the full match until you've worked at the company for a certain period. The good news is that 401(k) plans with employer contributions are regulated under the Employee Retirement Income Security Act (ERISA), which according to FINRA provides important participant protections—including requirements for plan transparency and fiduciary responsibilities for those managing plan assets.

If you leave your job before you're fully vested, you forfeit the unvested portion of employer contributions.

401(k) Withdrawal Rules

Understanding when and how you can access your 401(k) funds is crucial for retirement planning.

The Age 59½ Rule

The standard rule is simple: you can withdraw from your 401(k) without penalty once you reach age 59½. Withdrawals before this age typically incur a 10% early withdrawal penalty plus regular income taxes.

Exceptions to the Early Withdrawal Penalty

Certain situations allow you to access funds before 59½ without the 10% penalty:

• Rule of 55: Leave your job at age 55 or older and withdraw from that employer's plan
• Substantially Equal Periodic Payments (SEPP): Take regular distributions based on life expectancy
• Disability: Permanent disability as defined by the IRS
• Medical expenses: Unreimbursed medical expenses exceeding 7.5% of AGI
• Qualified Domestic Relations Order (QDRO): Court-ordered distributions in divorce

Required Minimum Distributions (RMDs)

Once you reach age 73, you must start taking minimum distributions from your traditional 401(k). The amount is based on your account balance and life expectancy. Failing to take RMDs results in a 25% penalty on the amount you should have withdrawn.

Roth 401(k)s are also subject to RMDs, but you can avoid this by rolling your Roth 401(k) into a Roth IRA, which has no RMDs during your lifetime.

How to Maximize Your 401(k)

Building substantial retirement savings requires a strategic approach. Here are proven strategies to get the most from your 401(k).

1. Always Capture the Full Employer Match

This is non-negotiable. If your employer offers a match, contribute at least enough to get every dollar of it. It's an immediate 50-100% return on your money.

2. Increase Contributions Annually

Many plans offer automatic contribution increases. Setting your contributions to increase by 1% each year helps you gradually reach higher savings rates without feeling a big impact on your paycheck.

3. Consider Your Tax Situation

If you're early in your career and in a lower tax bracket, Roth contributions might make sense. If you're in your peak earning years, traditional contributions can provide valuable tax breaks now.

4. Choose Low-Cost Investments

Investment fees eat into your returns over time. A fund with 1% annual fees versus 0.1% fees could cost you tens of thousands of dollars over a 30-year career. Look for index funds with low expense ratios.

5. Rebalance Periodically

As different investments grow at different rates, your portfolio can drift from your target allocation. Rebalancing once a year helps maintain appropriate risk levels.

Getting Started with Your 401(k)

If you have access to a 401(k) but haven't enrolled—or aren't contributing enough—here's how to take action:

1. Contact HR or access your benefits portal to find enrollment information
2. Start with at least the employer match percentage if you can
3. Choose target-date funds if you're unsure about investments
4. Set up automatic increases if your plan offers them
5. Review your account quarterly to ensure you're on track

For guidance on starting your investment journey, including how to think about asset allocation, our beginner's guide can help. And if you need to create a budget to find room for 401(k) contributions, we have resources for that too.

According to Fidelity's retirement guidelines, you should aim to save about 15% of your income annually for retirement, starting in your 20s. Their age-based milestones suggest having 1x your salary saved by 30, 3x by 40, 6x by 50, and 10x by 67.

401(k) vs. IRA: Understanding the Differences

While both 401(k)s and IRAs offer tax-advantaged retirement savings, they have important differences:

Many people use both accounts: contributing enough to their 401(k) to get the employer match, then maxing out an IRA, then returning to the 401(k) if they have more to save. Consider both traditional IRA and Roth IRA options based on your tax situation. Building strong financial health—including maintaining a good credit score—complements your retirement savings strategy.

Conclusion

A 401(k) is one of the most powerful tools available for building retirement wealth. With tax advantages, potential employer matching, and high contribution limits, it's the foundation of most Americans' retirement plans.

The key principles are simple: start as early as possible, always capture your full employer match, increase contributions over time, and let compound growth work in your favor. Whether you choose traditional or Roth contributions—or both—the most important step is to start.

Don't let complexity prevent you from taking action. Even if you can only contribute a small amount initially, getting started puts time on your side. Your future self will thank you for every dollar you save today.