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This simple guide simplifies retirement planning for a 401k, revealing how to build a secure financial future.

401(k) Plans: Everything You Need to Know

Disclaimer: This website and its content are for informational purposes only and is not financial advice.

A 401(k) is an employer-sponsored retirement plan. You contribute pre-tax (traditional) or after-tax (Roth) money, which grows tax-deferred or tax-free. Employers may match contributions!

What Exactly is a 401(k)?

A 401(k) is a type of retirement savings plan offered by many employers. It allows employees to contribute a portion of their pre-tax paycheck directly into an investment account. The money grows over time, and taxes are typically deferred until you withdraw the funds in retirement.

This means you don't pay income tax on the money you contribute or on any investment earnings until you take it out later in life. The name 401(k) comes from the section of the Internal Revenue Code that governs these plans.

How a 401(k) Works

When you participate in a 401(k) plan, you elect to have a certain amount or percentage of your salary automatically deducted from your paycheck and deposited into your 401(k) account. These contributions are made on a pre-tax basis, which lowers your current taxable income.

For example, if you earn $50,000 a year and contribute $5,000 to your 401(k), your taxable income for that year would be reduced to $45,000.

The money in your 401(k) is then invested in various options provided by your plan, such as mutual funds, bond funds, or target-date funds. The goal is for your investments to grow over many years, compounding your savings.

Employer Contributions to Your 401(k)

One of the most attractive features of a 401(k) is the potential for employer contributions, often referred to as a "company match." Many employers will match a percentage of the money you contribute to your 401(k) up to a certain limit. For instance, an employer might match 50% of your contributions up to 6% of your salary.

This is essentially free money that significantly boosts your retirement savings. It is highly recommended to contribute at least enough to receive the full employer match, as this is an immediate and guaranteed return on your investment.

Keep in mind that employer matching contributions may be subject to a vesting schedule, meaning you must work for the company for a certain period before you fully own their contributions. Additionally, for eligible employees, a 457(b) can be a crucial component of your comprehensive financial plan.

Updated May 26th, 2025

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Traditional vs. Roth 401(k)

When setting up your 401(k), you typically have two main options: a traditional 401(k) or a Roth 401(k). The primary difference lies in how your contributions are taxed. With a traditional 401(k), contributions are made with pre-tax dollars, meaning you get an immediate tax deduction, and your withdrawals in retirement are taxed as ordinary income.

A Roth 401(k), on the other hand, is funded with after-tax dollars. This means your contributions do not reduce your current taxable income, but qualified withdrawals in retirement are completely tax-free.

The choice between a traditional 401(k) and a Roth 401(k) often depends on your current income level and your expected tax bracket in retirement. If you anticipate being in a higher tax bracket in retirement, a Roth 401(k) might be more advantageous.

Contribution Limits for Your 401(k)

The Internal Revenue Service (IRS) sets annual limits on how much you can contribute to your 401(k) plan. These limits can change from year to year. For 2025, the employee contribution limit for a 401(k) is $23,500.

If you are age 50 or older, you can make an additional "catch-up contribution" of $7,500, bringing your total individual contribution limit for a 401(k) to $31,000.

There are also limits on the total combined contributions from both you and your employer to a 401(k), which for 2025 is $70,000 ($77,500 if age 50 or older).

401(k) Investment Options and Fees

Your 401(k) plan will offer a selection of investment options, usually a mix of mutual funds, exchange-traded funds (ETFs), and target-date funds. Mutual funds pool money from many investors to buy a diversified portfolio of stocks, bonds, or other securities.

Target-date funds are particularly popular for 401(k)s because they automatically adjust their asset allocation to become more conservative as you approach your target retirement date.

It is important to review the investment options available in your 401(k) and choose those that align with your risk tolerance and financial goals.

It's also crucial to be aware of the fees associated with your 401(k) plan. These fees can include administrative fees, investment management fees (often expressed as expense ratios), and individual service fees.

While fees might seem small, even a slight difference in fees can significantly impact your 401(k) balance over time due to compounding. Your employer is required to provide you with information about the fees in your 401(k) plan.

Withdrawal Rules and Rollovers for Your 401(k)

Generally, you can begin taking penalty-free withdrawals from your 401(k) at age 59 ½. Withdrawals before this age may be subject to a 10% early withdrawal penalty, in addition to regular income taxes, unless certain exceptions apply.

Once you reach age 73 (or 75 for those turning 74 after 2032), you will typically need to start taking required minimum distributions (RMDs) from your traditional 401(k) account. Roth 401(k) accounts do not have RMDs as of 2024.

When you leave an employer, you have several options for your 401(k) funds. You can leave the money in your former employer's plan if permitted, roll it over to your new employer's 401(k) plan, or roll it over into an Individual Retirement Account (IRA).

Rolling over your 401(k) into an IRA or a new 401(k) can offer more investment choices and potentially lower fees, while also keeping your retirement savings tax-deferred or tax-free. Cashing out your 401(k) is generally discouraged due to potential taxes and penalties.

Key Takeaways

A 401(k) plan is a powerful tool for building retirement wealth. Its tax advantages, the potential for employer matching contributions, and the power of compounding can help you accumulate a substantial nest egg over your working career.

By understanding the ins and outs of your 401(k), making consistent contributions, and wisely choosing your investments, you can put yourself on a strong path toward a comfortable and secure retirement.

Reviewing your 401(k) periodically and seeking professional financial advice can further optimize your strategy for future financial well-being.

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By Jordan McCaleb, Investment Researcher