How a 401(k) Works: Contributions, Growth, and Withdrawals

What a 401(k) is and how money moves through it

A 401(k) is a retirement savings account your employer sponsors. You contribute money from your paycheck before taxes are taken out, the money grows over time in investments you choose, and you withdraw it after age 59½. Your employer may match part of what you contribute — that's assistance programs added to your account.

The account is named after a section of the tax code. Your employer sets up the plan through a provider like Fidelity, Vanguard, or Schwab, and you enroll through your company's benefits portal or HR department. Money you put in reduces your taxable income for that year, which is why the contributions are called "pre-tax" or "traditional."

The account grows tax-free while the money sits there. You pay income tax on withdrawals after you retire, when you may be in a lower tax bracket. If you leave your job, you can roll the balance into an IRA or your new employer's plan to keep it growing without penalty.

Key Takeaways

• You contribute money from your paycheck before income tax, which lowers your taxable income in the year you contribute.
• Your employer may match a percentage of your contribution — commonly 3 to 6 percent — which is immediate additional savings.
• You choose how the money is invested from a menu of mutual funds and other options your plan offers.
• You can withdraw money penalty-free starting at age 59½; withdrawals before that age usually trigger a 10 percent penalty plus income tax.
• If you change jobs, you can roll your balance into an IRA or your new employer's plan without losing the tax-deferred growth.

Contribution limits and how much you can put in each year

The IRS sets an annual limit on how much you can contribute to your 401(k). That limit changes most years. For 2024, the limit is $23,500 if you are under age 50. If you are 50 or older, you can contribute an additional $7,500 as a "catch-up" contribution, for a total of $31,000.

These limits apply to your contributions only — they do not include employer matching. If your employer matches 5 percent of your salary and you contribute $23,500, the employer's match is separate and does not count toward your limit.

You set your contribution amount when you enroll, usually as a percentage of your paycheck. If you contribute 10 percent and earn $60,000 a year, you contribute $6,000 annually ($500 per month if paid monthly). You can change your contribution percentage during open enrollment each year, or sometimes mid-year if your life circumstances change — a marriage, birth, or job loss.

Employer matching and how to capture the full benefit

Many employers match a portion of what you contribute. A common match is 100 percent of the first 3 percent you contribute, plus 50 percent of the next 2 percent. That means if you earn $50,000 and contribute 5 percent ($2,500), your employer adds $2,000 — a 3 percent match on the first $1,500, plus a 50 percent match on the next $1,000.

To capture the full match, you need to contribute at least the percentage your employer matches. If your employer matches 3 percent and you only contribute 2 percent, you leave money on the table. Check your plan documents or ask HR what your company's match formula is — it varies widely.

Matching money is usually subject to a vesting schedule, which means you do not own it immediately. A common schedule is 20 percent per year over five years — after five years of employment, you own 100 percent of the match. If you leave before you are fully vested, you forfeit the unvested portion. Your own contributions are always 100 percent vested immediately.

How your money is invested and what happens to it

When you enroll, you choose how to invest your balance from a menu of options. Most plans offer mutual funds focused on stocks, bonds, or a mix of both. Some plans offer target-date funds, which automatically shift from stocks to bonds as you approach retirement — a fund labeled "2050" is designed for someone retiring around 2050.

You can usually change your investment choices once per year during open enrollment, or immediately if you experience a may have access to life event. Some plans allow you to change more frequently. Your contributions going forward go into whatever funds you select; money already invested stays where it is unless you move it.

The value of your account fluctuates with the market. If you invest in stock funds and the market drops, your balance drops too. If the market rises, your balance rises. Over long periods — 20 or 30 years — stock-heavy portfolios have historically grown more than bond-heavy ones, but with more year-to-year swings.

Withdrawal rules and what happens before age 59½

You can withdraw your balance penalty-free starting at age 59½. Withdrawals are taxed as ordinary income — if you withdraw $10,000 and are in the 22 percent tax bracket, you owe $2,200 in federal income tax on that withdrawal.

If you withdraw before age 59½, you owe a 10 percent penalty on top of income tax. A $10,000 withdrawal at age 45 costs you $1,000 in penalty plus income tax. There are narrow exceptions: withdrawals for disability, medical expenses exceeding 7.5 percent of your adjusted gross income, or a series of equal payments under IRS rules (called a 72(t) distribution) avoid the penalty, though you still owe income tax.

If you leave your job, you have options. You can leave the money in your former employer's plan if the balance is at least $5,000 (rules vary by plan). You can roll it into an IRA, which gives you more investment choices and lower fees. You can roll it into your new employer's plan if that plan accepts rollovers. Or you can cash it out, but that triggers immediate tax and the 10 percent penalty if you are under 59½.

Traditional 401(k) versus Roth 401(k) — the tax difference

A traditional 401(k) uses pre-tax money: you contribute before income tax, your contributions reduce your taxable income now, and you pay tax on withdrawals later. A Roth 401(k) uses after-tax money: you contribute after income tax, your contributions do not reduce your taxable income now, and withdrawals are tax-free after age 59½.

Which makes sense depends on your current tax bracket and what you expect in retirement. If you are in a high tax bracket now and expect to be in a lower one in retirement, traditional saves you more. If you are in a low bracket now and expect to be in a higher one, or if you simply want tax-free withdrawals later, Roth makes sense.

Not all employers offer both options — some offer only traditional, some offer both. If your plan offers both, you can split your contributions between them. The combined limit still applies: if you contribute $15,000 to traditional and $8,500 to Roth, you have hit the $23,500 limit and cannot contribute more that year.

Required minimum distributions and what happens at age 73

Starting at age 73, the IRS requires you to withdraw a minimum amount from your traditional 401(k) each year, called a required minimum distribution or RMD. The amount is calculated by dividing your account balance by a life expectancy factor published by the IRS. For someone age 73 with a $500,000 balance, the RMD might be roughly $18,000 that year.

You must take the RMD by December 31 each year, or you owe a 25 percent penalty on the amount you failed to withdraw (reduced to 10 percent if you correct it within two years). If you are still working and your employer's plan allows it, you may be able to delay RMDs from that plan until you actually retire.

Roth 401(k)s are subject to RMDs during your lifetime, unlike Roth IRAs. However, you can roll a Roth 401(k) into a Roth IRA to avoid RMDs after retirement.

Rolling over a 401(k) to an IRA when you change jobs

When you leave an employer, you can move your 401(k) balance to an IRA without paying tax or penalty. This is called a rollover. You have two options: a direct rollover or an indirect rollover.

In a direct rollover, your former employer's plan administrator sends the money directly to the IRA custodian (like Fidelity or Vanguard). You never touch the money, so there are no tax consequences. This is the simpler route and the one most people use.

In an indirect rollover, the plan sends you a check. You then deposit it into an IRA within 60 days. If you miss the 60-day window, the IRS treats it as a withdrawal, and you owe income tax plus the 10 percent penalty if you are under 59½. The plan also withholds 20 percent for taxes, so you have to come up with that amount from your own pocket to deposit the full balance and avoid a taxable shortfall.

After a rollover, your IRA typically offers more investment choices and lower fees than a 401(k). You can also convert a traditional IRA to a Roth IRA later if you want tax-free withdrawals, though you owe tax on the conversion in the year you do it.

Frequently Asked Questions

Can I borrow money from my 401(k)?

Many plans allow loans. You can typically borrow up to 50 percent of your vested balance, with a maximum of $50,000. You repay the loan through payroll deductions, usually over five years. If you leave your job before repaying, the loan balance is treated as a withdrawal, and you owe tax plus the 10 percent penalty if you are under 59½.

What happens to my 401(k) if I get laid off?

Your balance stays in the account and continues to grow. You can leave it there, roll it to an IRA, or roll it to your new employer's plan. You cannot make new contributions once you leave, but existing money keeps growing tax-deferred. If your balance is under $5,000, your former employer may force you to roll it out or cash it out.

Can I contribute to both a 401(k) and an IRA?

Yes. Your 401(k) contributions and IRA contributions are separate. You can max out both if your income allows. However, if you have a traditional IRA and earn above certain income thresholds, your 401(k) contributions may limit how much of your IRA contribution you can deduct on your taxes. Check IRS rules for your income level.

What if my employer does not offer a 401(k)?

You can open an IRA on your own through a bank or brokerage. A traditional IRA works similarly to a 401(k) — contributions may be deductible, growth is tax-deferred, and withdrawals are taxed. A Roth IRA uses after-tax money but offers tax-free withdrawals. IRAs have lower contribution limits than 401(k)s and fewer investment options at most providers, but no employer involvement is needed.

Can I withdraw from my 401(k) if I am in financial hardship?

Some plans allow hardship withdrawals for expenses like medical bills, home repairs, or education costs. You owe income tax and usually the 10 percent penalty. Hardship withdrawals are not loans — you do not repay them. Rules vary by plan, so check your plan documents or ask HR whether hardship withdrawals are available and what qualifies.