How a 401(k) Actually Works (And How to Get the Most Out of It)

A 401(k) is a workplace retirement account offered by many US employers. It lets employees contribute part of their pay directly from their paycheque, often with a matching contribution from the employer, and offers significant tax advantages designed to encourage long-term saving.

For workers with access to one, understanding how a 401(k) works — and specifically how to capture the employer match — is one of the single most valuable financial skills available. Verify current-year limits and rules at irs.gov before making decisions.

How contributions work

You choose a percentage of your salary to contribute each pay period. If you choose Traditional 401(k), the money is deducted before income tax, reducing your taxable income now; withdrawals in retirement are taxed as ordinary income. If your plan offers a Roth 401(k), you contribute after tax and qualified withdrawals in retirement are tax-free. Many plans allow you to split contributions between the two.

The IRS sets an annual contribution limit that typically rises with inflation — in recent years it has been in the $23,000 range for workers under 50, with an additional catch-up contribution for workers age 50 and older. Check the current-year limit at irs.gov before setting your contribution rate.

The employer match — usually the best return you will ever see

Many employers match a portion of your contributions. A common structure is "100% of the first 3% of pay, plus 50% of the next 2%," which produces a maximum match of 4% of salary. If you earn $60,000 and contribute at least 5% ($3,000), the employer adds $2,400 — an immediate 80% return on your contribution before markets do anything.

If you do nothing else, contribute at least enough to capture the full employer match. Passing on a match is one of the most common — and expensive — financial mistakes.

Vesting

Your own contributions are always 100% yours. The employer's match may be subject to a vesting schedule, meaning it becomes fully yours only after a set number of years of employment. Common schedules include immediate vesting, three-year cliff vesting, and graded vesting over five or six years. Check your plan's summary description to see what applies to you.

Choosing your investments

Inside the 401(k), you choose from a menu of investment options selected by the plan administrator. Most plans include several index funds, actively managed funds, and target-date funds. For most workers, a low-cost target-date fund matched to your expected retirement year is a reasonable default — it automatically holds a diversified mix of stocks and bonds and gradually shifts toward more bonds as retirement approaches. If you prefer to build your own allocation, look for the lowest-cost total-market or S&P 500 index option available.

What happens when you change jobs

When you leave an employer, your 401(k) balance stays yours. You typically have four options: leave it in the old plan (if allowed), roll it over into your new employer's plan, roll it over into an IRA, or cash it out. Cashing out is almost always a bad idea for anyone under 59½ — the money is taxed as ordinary income and hit with a 10% early-withdrawal penalty. Rolling into an IRA usually offers the broadest investment choice and lowest fees.