What Is a 401(k) and How Does It Work?
Free money from your employer, a tax break from the government, and decades of compounding, all wrapped into one payroll deduction most people barely notice.
The basic mechanics
A 401(k) is an employer-sponsored retirement account that lets you contribute a portion of your paycheck before it’s taxed, invest that money, and let it grow tax-deferred until retirement. The name comes from the section of the Internal Revenue Code that created it. Contributions are deducted automatically from your paycheck, which is part of why it’s one of the easier ways to save consistently: the money never lands in your checking account to be spent on something else first.
Traditional 401(k) contributions reduce your taxable income for the year you make them. If you earn $75,000 and contribute $7,500 to a traditional 401(k), you’re generally taxed as though you earned $67,500, with the deferred amount and any growth taxed later, when you withdraw it in retirement.
The employer match: money you shouldn’t leave behind
Many employers match a portion of what you contribute, up to a set limit, as an incentive to participate. A common structure is a 50% match up to 6% of salary, meaning the employer contributes 50 cents for every dollar you put in, up to 6% of your pay.
On a $75,000 salary, contributing 10% of pay ($7,500 a year) with that match structure means the employer adds another $2,250 a year (50% of the matched 6%, or $4,500, times 50%), for a combined $9,750 going into the account annually from a $7,500 contribution out of your own paycheck. Contributing less than the match threshold means leaving part of that employer money unclaimed, which is why financial advisors so consistently emphasize contributing at least enough to capture the full match before directing savings elsewhere.
Contribution limits for 2026
The IRS sets an annual limit on how much you can contribute to a 401(k) through your own paycheck deferrals. For 2026, that limit is $24,500. Workers age 50 and older can contribute an additional catch-up amount of $8,000, for a total of $32,500. A further, higher catch-up limit of $11,250 applies specifically to workers aged 60 through 63, under rules introduced by the SECURE 2.0 Act, bringing their total allowed contribution higher still. These limits apply to your own contributions; employer matching contributions don’t count against this specific cap, though a separate, higher combined limit applies to the total of employee and employer contributions together.
Traditional versus Roth 401(k)
Many employer plans now offer a Roth 401(k) option alongside the traditional version. A traditional 401(k) contribution is made pretax, lowering your taxable income now, with withdrawals taxed as ordinary income in retirement. A Roth 401(k) contribution is made with money you’ve already paid tax on, so it doesn’t lower your taxable income today, but qualified withdrawals in retirement, including all the investment growth, come out entirely tax-free.
The choice between the two often comes down to a bet on your own future tax bracket. If you expect to be in a lower tax bracket in retirement than you are now, the traditional option’s upfront deduction is generally more valuable. If you expect to be in the same or a higher bracket later, paying tax now through the Roth option can work out better, since it locks in today’s rate on money that might otherwise be taxed at a higher rate down the road.
Vesting: when the employer match actually becomes yours
Your own contributions are always 100% yours immediately. Employer matching contributions are often subject to a vesting schedule, meaning you earn full ownership of that money gradually over a set number of years of employment, rather than all at once. Leave the company before you’re fully vested, and you can forfeit some or all of the unvested employer contributions, even though the money technically sat in your account. Vesting schedules vary by employer and are detailed in your plan’s summary description.
A common structure is graded vesting, where a set percentage of employer contributions becomes yours each year, reaching full ownership after several years. Some employers instead use cliff vesting, where you own none of the match until a specific milestone, often three years, at which point you become fully vested all at once. Checking your own plan’s vesting schedule matters most if you’re weighing a job change, since leaving shortly before a vesting milestone can mean forfeiting a meaningful amount of already-earned match money.
What happens when you leave a job
A 401(k) doesn’t disappear when you change employers. Common options include leaving the money in the old plan if allowed, rolling it into your new employer’s 401(k), or rolling it into an individual retirement account (IRA). Cashing it out entirely is generally the least favorable option for anyone under retirement age, since it typically triggers both ordinary income tax and an additional early withdrawal penalty on top.
Rollovers, when done correctly as a direct transfer between accounts, don’t trigger taxes or penalties, since the money never technically passes through your own hands. An indirect rollover, where a check is issued to you personally, comes with a stricter deadline, typically 60 days, to redeposit the full amount into a new qualified account, or the transaction can be treated as a taxable withdrawal instead.
What actually happens to the money
Contributions don’t just sit as cash; they’re invested according to choices you make from a menu of options your employer’s plan offers, typically a selection of mutual funds spanning different risk levels, from conservative bond funds to more aggressive stock funds, along with target-date funds that automatically shift toward a more conservative mix as you approach a chosen retirement year. The account’s eventual value depends on how much is contributed, how it’s invested, and how long it stays invested, the same three levers that drive growth in any long-term investment account.
Fees matter more than many participants realize. Every 401(k) plan carries some combination of administrative fees and the expense ratios of the specific funds offered, and these costs are deducted from the account’s returns whether or not you actively notice them. A plan with meaningfully higher fees than another, holding everything else equal, will produce a smaller balance over a multi-decade career, simply because a larger share of the growth gets consumed by costs along the way.
Project your own balance
Your eventual 401(k) balance depends on your salary, contribution rate, employer match, assumed investment return, and years until retirement. Our 401(k) Calculator models all of these together, showing your combined annual contribution and a projected balance at retirement.
Common questions about 401(k) plans
For 2026, the employee contribution limit is $24,500. Workers 50 and older can contribute an additional $8,000 catch-up amount, for a total of $32,500, and workers aged 60 through 63 have a higher catch-up limit of $11,250 under SECURE 2.0 provisions.
Effectively yes, within the matched portion. It’s compensation your employer provides only if you contribute enough to trigger it, which is why not contributing at least up to the match threshold is generally considered leaving part of your compensation unclaimed.
Generally, withdrawals before age 59½ are subject to a 10% early withdrawal penalty on top of ordinary income tax, with limited exceptions such as certain hardship withdrawals or a 401(k) loan, which must be repaid, typically through payroll deductions.
401(k) assets are held in trust separately from the employer’s own business assets specifically to protect them in this scenario, so the funds in your account generally aren’t at risk if your employer fails. You’d typically still be able to roll the account into an IRA or a new employer’s plan.
For 2026, the employee contribution limit is $24,500. Workers 50 and older can contribute an additional $8,000 catch-up amount, and workers 60-63 have a higher catch-up limit of $11,250 under SECURE 2.0.
Effectively yes, within the matched portion. It’s compensation your employer provides only if you contribute enough to trigger it, which is why not contributing up to the match is generally leaving pay unclaimed.
Generally, withdrawals before age 59½ face a 10% early withdrawal penalty on top of ordinary income tax, with limited exceptions like certain hardship withdrawals or a 401(k) loan that must be repaid.
You can leave it in the old plan if allowed, roll it into your new employer’s plan, or roll it into an IRA. Cashing it out is generally the least favorable option, since it triggers taxes and often a penalty.