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

A 401(k) is a workplace retirement account where you and your employer set aside money before taxes, the account grows over time, and you withdraw it after age 59½

Your employer sets up a 401(k) plan through a financial services company like Fidelity, Vanguard, or Schwab. You choose how much to contribute from each paycheck—that money goes directly from your salary into your account before federal income tax is calculated. Your employer may add matching contributions (typically 3 to 6 percent of your salary). The money sits in investments you select, grows tax-free while it's in the account, and you pay income tax only when you withdraw it in retirement.

The account is yours to keep even if you change jobs. If you leave your employer, you can roll the balance into an Individual Retirement Account (IRA) or into your new employer's plan. You cannot touch the money penalty-free until you turn 59½, with narrow exceptions for hardship or disability. At age 73, you must begin taking required minimum distributions (RMDs)—the IRS calculates how much based on your age and account balance.

Key Takeaways

• Money you contribute reduces your taxable income for the year, lowering your federal income tax bill immediately.
• Your employer's matching contribution is assistance programs that vests (becomes yours) over a set schedule, usually three to five years.
• You choose from a menu of mutual funds and other investments offered by your plan; the account grows tax-free until withdrawal.
• Withdrawals before age 59½ trigger a 10 percent early withdrawal penalty plus income tax, except in cases of disability, medical hardship, or other narrow exceptions.
• Once you leave your job, you can roll your 401(k) into an IRA or your new employer's plan to keep the tax-deferred growth going.

How Money Enters Your 401(k)

You decide what percentage of your gross paycheck to contribute, up to a dollar limit set by the IRS each year. For 2024, that limit is $23,500 if you are under age 50; if you are 50 or older, you can add an extra $7,500 catch-up contribution. Your employer deducts that amount before calculating your federal income tax, so a $500 contribution reduces your taxable income by $500 that pay period.

Your employer may also contribute. A common structure is a 100 percent match up to 3 percent of your salary—meaning if you earn $50,000 and contribute 3 percent ($1,500), your employer adds another $1,500. Some employers match a smaller percentage, and some offer a flat contribution to all employees regardless of what they contribute. That employer money is not taxed to you when it enters the account, but it does count toward your annual contribution limit in some plans.

Employer contributions usually vest over time. Vesting means the money becomes permanently yours. A common vesting schedule is 20 percent per year over five years, so after five years of employment, 100 percent of the employer contributions are yours. If you leave before vesting is complete, you forfeit the unvested portion—it goes back to your employer's plan.

How Your 401(k) Grows

Once money is in your account, you direct it into investments. Your plan offers a menu of choices—typically 10 to 30 mutual funds, target-date funds, and sometimes individual stocks or bonds. You can split your contributions among multiple funds or put everything into one. You can change your allocation at any time, and many people adjust it as they get closer to retirement, moving from aggressive growth funds to more conservative options.

The growth—whether it is dividends, interest, or capital gains—is not taxed while the money stays in the account. If a fund inside your 401(k) gains 8 percent in a year, you do not owe tax on that 8 percent gain that year. That tax deferral is the main advantage of a 401(k) over a regular taxable investment account. Over decades, that compounding effect can roughly double or triple your money.

You pay no tax on the growth until you withdraw the money. At that point, the entire withdrawal—your original contributions plus all the growth—is taxed as ordinary income at whatever tax rate applies to you that year.

Withdrawal Rules and Penalties

You cannot withdraw money from your 401(k) before age 59½ without a penalty, with a few exceptions. The standard penalty is 10 percent of the amount withdrawn, plus you owe income tax on it. So a $10,000 withdrawal at age 45 costs you $1,000 in penalty plus whatever income tax bracket you are in—potentially another $2,200 to $3,700 depending on your income.

The exceptions are narrow. You can withdraw without the 10 percent penalty if you are disabled, if you are a beneficiary receiving a distribution after the account holder's death, or if you are taking substantially equal periodic payments (a complex calculation that locks you into a specific withdrawal amount for five years or until age 59½, whichever is longer). Some plans allow loans—you borrow from your own account and repay it with interest—but loans must be repaid within five years or they become taxable withdrawals.

A few plans offer hardship withdrawals for immediate financial need: medical bills, home purchase, tuition, or preventing eviction. Hardship withdrawals still trigger the 10 percent penalty and income tax; the plan simply waives its own restrictions. You must prove the hardship and show you have no other funds available. Rules vary by plan, so check your plan document or ask your benefits administrator whether your situation qualifies.

What Happens When You Leave Your Job

Your 401(k) stays in the plan even after you leave your employer. You have four options: leave it where it is, roll it into your new employer's 401(k), roll it into a traditional IRA, or cash it out. Cashing it out triggers the 10 percent penalty (if you are under 59½) plus income tax on the full amount, so it is rarely the best choice unless the balance is very small.

A direct rollover to an IRA or new employer plan avoids any tax or penalty. The money moves directly from the old plan to the new account; you never touch it. This is the cleanest option and keeps the tax deferral intact. An indirect rollover means the old plan sends you a check, and you have 60 days to deposit it into an IRA or new plan. If you miss the 60-day window, the IRS treats it as a taxable withdrawal and you owe the 10 percent penalty plus income tax.

If you roll into a traditional IRA, you can invest in a much wider range of options—individual stocks, bonds, real estate investment trusts, and thousands of mutual funds. If you roll into your new employer's 401(k), you are limited to that plan's investment menu, but you keep everything in one workplace account.

Tax Treatment: Now Versus Later

A 401(k) is a pre-tax account, meaning contributions reduce your taxable income this year. If you earn $60,000 and contribute $6,000 to your 401(k), your taxable income for federal purposes is $54,000. You save tax now at your current rate—if you are in the 22 percent bracket, that $6,000 contribution saves you $1,320 in federal tax this year.

The tradeoff is that you pay tax later. When you withdraw money in retirement, every dollar is taxed as ordinary income. If you are in the 22 percent bracket in retirement, that $6,000 contribution plus its growth will be taxed at 22 percent when you withdraw it. If your tax bracket is lower in retirement, you come out ahead. If it is higher, you pay more tax than you would have if you had invested the money in a regular taxable account.

Some employers also offer a Roth 401(k) option, where contributions are made after tax (you do not get a deduction now) but withdrawals in retirement are tax-free. Roth contributions count toward the same annual limit as pre-tax contributions, so you choose how to split your $23,500 limit between the two types.

Required Minimum Distributions at Age 73

The IRS requires you to begin withdrawing money from your 401(k) at age 73 (the age changed from 72 in 2023). The amount is calculated by dividing your account balance on December 31 of the prior year by a life expectancy factor published by the IRS. For example, at age 73, the factor is roughly 26.5, so a $500,000 balance would require a minimum distribution of about $18,868 that year.

You must take the distribution by December 31 each year, or the IRS imposes a 25 percent penalty on the amount you failed to withdraw (reduced to 10 percent if you correct it within two years). The distribution is taxed as ordinary income. If you do not need the money, you still must withdraw it and pay tax on it, though you can donate it to charity through a may have access to charitable distribution, which avoids the tax.

If you are still working and do not own more than 5 percent of the company, you may be able to delay RMDs until you actually retire. Check with your plan administrator about the "still-working exception."

Frequently Asked Questions

Can I contribute to a 401(k) and an IRA in the same year?

Yes. Your 401(k) contributions and IRA contributions are separate limits. You can contribute up to $23,500 to a 401(k) and up to $7,000 to a traditional or Roth IRA in 2024 (or $8,000 if you are 50 or older). However, if you have a high income and contribute to a traditional IRA, the deduction may be limited if you also have a 401(k).

What happens to my 401(k) if I die?

Your beneficiary (usually a spouse, child, or estate) inherits the account. They can roll it into an inherited IRA and take distributions over their lifetime, or take a lump sum and pay income tax on it. Spouses have more flexibility than non-spouse beneficiaries, so naming your spouse as beneficiary is often the best choice if applicable.

Can I borrow from my 401(k)?

Many plans allow loans up to 50 percent of your vested balance or $50,000, whichever is less. You repay the loan with interest (usually the prime rate plus 1 percent) over five years. If you leave your job, the loan is typically due within 60 days or it becomes a taxable withdrawal. Loans reduce the money available to grow, so they should be a last resort.

Is my 401(k) protected if I file for bankruptcy?

Yes. 401(k) accounts are generally protected from creditors and bankruptcy proceedings under federal law. IRAs have some protection too, though the rules vary by state. This is one reason rolling a 401(k) into an IRA after leaving a job requires careful planning if you have creditor concerns.

What if my employer stops matching contributions?

Your contributions still go in and grow tax-free. You lose the free employer money going forward, but any matching contributions already made and vested remain yours. Some employers suspend matching during downturns and restart it later. Check your plan document or ask your benefits administrator about the company's policy.