401(k) Plan Overview: Definition, How It Works, & Guidelines

A 401(k) plan has multiple tax advantages and the ability to earn matching contributions, making it easier to save for retirement than other investment accounts.

There are several different account types your employer may offer with different perks and limits that can help with your retirement planning.

What is a 401(k) plan?

An easy 401(k) definition is that your employer provides a tax-advantaged retirement plan to invest a portion of your paycheck.

You designate a percentage of your salary to invest and your workplace may match a certain amount.

How does a 401(k) work?

A 401(k) is the most common type of defined contribution plan where you—the employee—voluntarily contribute a fixed amount or percentage of your earned income.

Your employer may also offer a 403(b) or a Thrift Savings Plan (TSP) which operate similarly. 

You decide how much to invest directly from your paycheck into investment choices that your 401(k) offers. Typically, that’s stock and bond index funds, target date retirement funds, and company stock. 

This retirement plan is separate from a pension or similar defined benefit plans that require an employer to contribute to your nest egg without you participating first. 

Unfortunately, employers are not required to offer 401(k)s or similar workplace retirement plans. If you’re in this situation, consider opening an individual retirement account (IRA) to enjoy tax-advantaged retirement contributions.

Tax advantages

• Today, you can choose from traditional tax-deferred or Roth post-tax contributions. You choose whether to pay the corresponding tax upfront or during retirement. Initially, only tax-deferred contributions were permissible in exchange for an immediate tax deduction.
• Congress authorized the first 401(k) plans with the passage of the Revenue Act of 1978. Specifically, this retirement plan derives its name from Section 401(k) of the Internal Revenue Code permitting tax-deferred contributions. 
• This addition to the tax code allows workers to make elective deferrals from their paychecks to save for retirement in a tax-advantaged investment account. Moreover, you get to deduct the contribution amount upfront but you pay taxes on the distribution amount.
• Your traditional 401(k) tax liability depends on your tax bracket during the distribution year. Additionally, you will likely encounter a 10% additional tax penalty on early withdrawals before age 59 ½.
• Since 2006, employers can also offer Roth 401(k) plans for tax-free distributions. However, you won’t qualify for an upfront tax deduction like a traditional tax-deferred plan. You must be at least 59 ½ and the account open for at least five years to waive the 10% penalty.

Vesting

Your employer may offer matching contributions, but vesting rules may apply that forfeit a portion of this “free money” if you change jobs or cease employment.

Two different vesting schedules are possible:

• Cliff vesting: Become fully vested all at once after a maximum three-year waiting period.
• Graduated vesting: Also known as “graded vesting,” you become fully vested over six years.  

As a personal example, I quit my job after seven years and didn’t forfeit any of the matching contributions. That includes the matches from my last contributions.

Below is an example showing vesting percentage examples for both options.

Years of Service	Cliff Vesting	Graduated Vesting
1	0%	0%
2	0%	20%
3	100%	40%
4	100%	60%
5	100%	80%
6	100%	100%

Remember that employers can be more aggressive and offer full vesting sooner.

Additionally, some 401(k) plans, such as a safe harbor 401(k) require immediate 100% vesting so you own the match right away.

Types of 401(k) Plans

Your employer may offer one or more of these tax-advantaged plans:

Traditional 401(k)

Contributions are tax-deductible during the contribution year and grow tax-deferred as you pay taxes on the distribution amount. You lower your taxable income upfront but must start taking required minimum distributions (RMDs) at age 73.

Roth 401(k)

After-tax contributions don’t reduce your taxable income but your distributions are tax-free. Further, you’re not required to take RMDs.

Safe Harbor 401(k):

This 401(k) plan requires fully-vested employer matching contributions that are yours to keep if you stop employment at any time. In comparison, other plans may require a minimum employment length for employer matches to vest.

SIMPLE 401(k)

This plan is specifically for businesses with fewer than 100 employees who receive at least $5,000 in compensation for the previous calendar year. This plan also requires immediate fully-vested employer matching contributions.

Your human resources department or 401(k) plan administrator can review the particular tax benefits and vesting timelines.

Pros & Cons

Here are the significant advantages and disadvantages of a 401(k) retirement plan.

Pros

• Tax-advantaged contributions: You can enjoy tax-deductible contributions with a traditional 401(k) or tax-free Roth 401(k) withdrawals. 
• Matching contributions: Your employer has the ability to match a portion of your contributions. This perk means you may not have to allocate as much of your salary to achieve your annual funding goals.  
• High contribution limits: The annual 401(k) contribution limits are substantially higher than IRAs, allowing you to save more each year for retirement. Further, the maximum income limits are higher making it easier for high earners to be fully eligible.
• Can make IRA contributions too: The 401(k) contribution limits are independent from IRAs and health savings accounts (HSAs). It’s possible to contribute to all three each calendar year. 
• Direct paycheck withholdings: You’re able to automate your contributions from your gross income instead of from your take-home pay which can make household budgeting and tax planning easier.

Cons

• Not available everywhere: A 401(k) or similar workplace plan is not a mandatory employee benefit. Nor do they need to make matching contributions. 
• Required minimum distributions (RMDs): Tax-reportable mandatory distributions activate for traditional 401(k)s upon turning 73. Potential penalties apply if you don’t make sufficient withdrawals by the deadline. 
• Plan administrator fees: An annual plan maintenance fee applies that can be a fixed amount or percentage of your portfolio balance. Mutual funds also have an operating expense ratio.

401(k) Contribution Limits

The annual contribution limits for 401(k)s are the most generous for retirement plans.

You’re able to split your contributions between traditional and Roth 401(k) plans and the annual contribution deadline is December 31.

Contribution Type	Contribution Limit (2024)
Employee contributions	$23,000
Catch-up contribution (employees 50 or older)	$8,000
SIMPLE 401(k) contributions	$16,000
Combined employer and employee contributions	$69,000 ($76,500 for catch-up contributions)

Employer Matching Explained

Your employer may decide to match a percentage of your contributions. The matching policy differs by employer and—as a reminder— is optional. The average match falls between 4% and 6%.

For example, my employer matched the first 6% of my salary. 

Typically, the matching contributions go into a traditional, tax-deferred account but the Secure 2.0 Act now allows employers to provide post-tax Roth matches for vested employees.

What types of investments can a 401(k) have?

Investment choices differ by plan provider and typically include a combination of stock and bond mutual funds:

• Bond Funds: Income-focused mutual funds that invest in short-term, intermediate, and long-term government and corporate bonds.
• Foreign Funds: Get exposure to international stocks and bonds to not exclusively rely on domestic stocks.
• Index Funds: Passive investment vehicles which match the investment performance of its target benchmark such as the S&P 500 or Russell 2000. These funds have lower expense ratios than actively managed funds trying to outperform the market.  
• Large-cap Funds: Invests in the largest publicly-traded companies, typically belonging to the S&P 500 or Nasdaq 100. These funds are more likely to hold blue chip companies that tend to be less volatile and more likely to earn dividend income. 
• Small-cap Funds: Usually members of the Russell 2000, smaller companies can have more upside potential during bullish periods but are inherently more volatile.
• Real Estate Funds: A real estate investment trust (REIT) can earn dividend income and provide diversification from traditional stocks and bonds. 

In most cases, you can only invest in mutual funds that your plan provider chooses.  Publicly-traded companies may offer a company stock investment option. You can also opt for managed portfolios for a small additional fee to recommend a diversified portfolio. 

Unfortunately, you usually can’t invest in ETFs or individual stocks like an IRA or brokerage account allows. Additionally, you can’t buy mutual funds outside your plan offering.

For example, my Vanguard was my previous 401(k) plan provider but I didn’t have access to every Vanguard mutual fund although the options made it easy to diversify.

When can you withdraw from your 401(k)?

You can start making penalty-free withdrawals upon turning 59 ½.

Qualified distributions from a traditional IRA are taxable at your then-current income tax bracket while Roth withdrawals are tax-free as you pay the obligation at contribution time.

Even if you’re age-eligible, your Roth 401(k) must also be open at least five years to avoid potential taxes and penalties.  
A mandatory 20% tax withholding may apply for traditional withdrawals to cover your estimated income tax bill.

Your plan provider furnishes a year-end tax document declaring your total distribution amount and any tax withholdings.

Early 401(k) Withdrawals

You can make early withdrawals before reaching retirement age, although taxes and penalties apply in most situations. 

The tax treatment differs by plan type:

• Traditional 401(k) early distributions: Entire withdrawal is subject to ordinary income tax and an additional 10% penalty. 
• Roth 401(k) early distributions: Withdrawals incur a 10% penalty, but only your non-contributions (i.e., investment gains and tax-deferred employer matches) are taxable. You won’t encounter double taxation on your original contribution amount.

Some of the withdrawals to waive taxes and penalties include:

• Hardship withdrawals of up to $1,000 per year (penalty-free when repaid within three years)
• Birth or adoption expenses of up to $5,000 per child
• Federally-declared disasters (up to $22,000)
• First-time home purchase (up to $10,000)
• IRS tax levies
• Medical insurance premiums during unemployment
• Qualified higher education expenses
• Total or permanent disability
• Unreimbursed medical expenses (exceeding 7.5% of adjusted gross income)

The IRS provides more examples of penalty-free early distributions.

401(k) Loan

You may also explore a 401(k) loan to borrow money from your retirement balances without paying taxes and penalties. Your plan provider may let you borrow up to 50% of your vested dollars and pay it back with interest over five years.

It’s critical to pay off the loan before the repayment period ends as any remaining balance is considered an early withdrawal, resulting in taxes and penalties. 

Further, your outstanding balance won’t earn investment gains while serving as loan collateral. Still, your repaid balance enjoys its traditional or Roth tax benefits and the opportunity to remain invested.

Required Minimum Distributions

Tax-deferred retirement accounts such as a traditional 401(k) or IRA start required minimum distributions (RMDs) when you turn 73.

The RMDs are a taxable event and not taking a sufficient distribution by December 31 incurs an additional 25% penalty.  

You can calculate your RMD by dividing your ending balance on December 31 of the prior year by the corresponding life expectancy factor for your current age. Your factor can be found in IRS Publication 590-B and the minimum distribution most likely increases yearly.

For example, the estimated RMD for a 79-year-old with a $1 million 401(k) plan balance is $47,393.37. However, the estimate is only $37,735.85 for a 73-year-old with a similar balance, but their future RMD estimates increase resulting in progressively larger withdrawals.

Your tax planner can help calculate your current-year RMD and future distributions.

Traditional 401(k) vs. Roth 401(k)

You can contribute specifically to a traditional 401(k), Roth 401(k), or both up to the contribution limit. However, the tax benefits and RMD requirements are notably different.

Criteria	Traditional 401(k)	Roth 401(k)
Tax-Deductible Contributions	Yes	No
Tax Treatment on Distributions	Tax-deferred, due during the distribution year	Tax-free
Withdrawal Requirements	RMDs start at age 73	None
Employer Contributions	Yes	Yes
Best For	Upfront tax deductions and lower retirement tax bracket	Tax-free withdrawals and a higher retirement tax bracket

A general rule of thumb is to choose a traditional 401(k) if you anticipate being in a lower tax bracket during retirement as you get the initial tax deductions and potentially pay fewer taxes later on.

Roth 401(k)s are better if you expect to land in a significantly higher tax bracket. It’s more affordable to forfeit the tax deduction and pay your tax bill right away.

401(k) vs. Brokerage Account

A brokerage account is better for non-retirement investment goals as you avoid early distribution penalties before age 59 ½ and you have more investment options.

Criteria	401(k)	Brokerage Account
Eligibility	Only available through participating employers	At least 18 years old, regardless of employer
Investment Options	Primarily stock and bond mutual funds	Stocks, bonds, ETFs, mutual funds, and commodities
Tax Advantages	Traditional 401(k): Tax-deductible contributions with tax-deferred gains Roth 401(k): Tax-free investment gains and distributions	None
Required Minimum Distributions	Traditional 401(k): Starts at age 73 Roth 401(k): None	None
Best For	Tax-advantaged retirement income	Non-retirement investing and distributions before age 59 1/2

What are my 401(k) options if I leave my job?

Depending on your retirement strategy, you have several possibilities to keep your assets in a retirement account or cash out for instant access.

1. Transfer to a new employer: You can move your previous employer’s 401(k) to your next employer. Your former plan administrator should offer direct rollovers to avoid taxes and fees. Consider this option if it has low fees and good investment choices.  
2. Convert to an IRA: A 401(k) rollover to a traditional or Roth IRA can be the best option if your new workplace doesn’t have a retirement plan. This option helps you avoid annual account maintenance fees and allow you to invest new funds. 
3. 401(k) cash out: Employers usually liquidate account balances smaller than $1,000, resulting in a tax-reportable event. You may also decide to withdraw the balance voluntarily, but taxes and penalties typically incur before age 59 1/2.
4. Keep it open: Sometimes, taking immediate action is unnecessary. While you might not contribute new money, keeping your old 401(k) open lets you maintain a tax-advantaged portfolio while figuring out your next career move. 
5. Open a gold IRA: You can also roll over your 401(k) into a gold IRA. This self-directed IRA lets you buy physical gold, silver, and precious metals within a week and keep enjoying traditional or Roth tax benefits.

How do you set up a 401(k) plan?

Your employer helps set up your 401(k) plan through the following steps:

1. Speak with your employer: Your workplace HR department or employee benefits manager provides the onboarding details to connect your personal account with the plan provider. The company likely offers automatic enrollment unless you opt out.
2. Decide between Roth or traditional 401(k): Your provider offers traditional and Roth 401(k)s. You can open one or both to optimize your tax situation. 
3. Choose contribution amount: Pick a percentage you want to invest in each pay period. At a minimum, consider contributing enough to max out the employer match. You may also enroll in automatic contribution increases such as 1% more per calendar year. 
4. Select investments: You can choose the asset allocation from the available funds available within your plan. The investment platform may offer managed portfolios or planning tools to suggest a model portfolio for your risk tolerance and age.
5. Rebalance periodically: It’s wise to regularly rebalance your overweight and underweight positions to maintain a diversified portfolio. You may also adjust as your goal, tax situation, and salary changes to keep saving for retirement.

What happens if you’re self-employed? There are several solo 401(k) companies that can guide you through the process to enjoy similar tax benefits and contribution limits.

You have the liberty of comparing fees, investment choices, and customer service quality to pick the best provider.

Is having a 401(k) a good idea?

A 401(k) is one of the best ways to accumulate tax-advantaged retirement savings thanks to its high annual contribution limits and employer-matching contributions.

The tax deductions help high-income households, while the Roth 401(k) provides peace of mind to all.

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