What is a 401(k) and How Does it Work?

This post covers everything you need to know about 401(k) plans including the benefits of participation and your options when changing jobs. As a bonus, we’ll also outline steps to take if you’re uncomfortable with large swings in the value of your 401(k) investments. Let’s dive in.

Key Takeaways

• A 401(k) is an employer-sponsored retirement plan funded straight from your paycheck, where contributions grow tax-deferred — or tax-free in a Roth 401(k).
• Most employers match part of what you contribute, so aim to put in at least enough to capture the full match — it's essentially free money.
• For 2026, you can defer up to $24,500, plus an $8,000 catch-up at age 50+ (or $11,250 at ages 60–63).
• New for 2026: high earners (more than $150,000 in prior-year wages) must make catch-up contributions on a Roth basis.
• Withdrawals before age 59½ generally trigger a 10% penalty plus taxes — though exceptions like the rule of 55, hardship withdrawals, and 401(k) loans exist — and required minimum distributions (RMDs) begin at age 73, or 75 if you were born in 1960 or later.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement account that enables employees to contribute a portion of their salary to the same. In addition to its tax benefits, one primary 401(k) advantage is that most employers match employee contributions (up to a predefined percentage)—essentially “free money” for the participating employee!

401(k) account types

Three ways a 401(k) can be funded

Most people use a traditional 401(k), but knowing all three helps you build tax flexibility for later.

Traditional

The most common

Contributions

Pre-tax—lowers taxable income now

Growth

Tax-deferred

Withdrawals

Taxed as ordinary income

Roth

Tax-free later

Contributions

After-tax—no deduction now

Growth

Tax-free

Withdrawals

Tax-free in retirement

After-tax

Contribute more

Contributions

After-tax; well above the standard limit

Growth

Tax-deferred on earnings

Withdrawals

Contributions come out tax-free; only earnings are taxed

Owning both traditional and Roth balances gives you tax diversification—some assets taxed on withdrawal, some not. Roth and after-tax options are less common; check what your plan offers. General information, not individual tax advice.

Traditional 401(k)

A traditional 401(k) is an employer-sponsored retirement account that comprises various investments—typically stocks, bonds, and mutual funds—that employees can choose from themselves or with the help of a financial advisor. Employees who wish to participate can invest a percentage of their pre-tax income to fund their account, with the money coming out of their paychecks automatically.

Roth 401(k)

Some employers also offer a Roth 401(k) plan, which works like a traditional 401(k) but is funded with after-tax dollars and features tax-free withdrawals during retirement. Owning a Roth 401(k) is sometimes beneficial as it’s difficult to predict which specific tax bracket you'll fall into years from now. With this in mind, participating in both types of 401(k) accounts can provide some level of tax diversification: fully taxing some of your assets upon withdrawal but not others.

Thanks to SECURE 2.0, some plans now also let you receive your employer's matching contributions as Roth money rather than pre-tax. If your plan offers this and you elect it, you'll owe income tax on the match in the year it's contributed — but that money, and its growth, can later be withdrawn tax-free. Note the match must be fully vested to qualify.

After-tax 401(k) contributions

Some employers also offer a third option: an after-tax 401(k) contribution account, essentially a hybrid of both a Roth and traditional 401(k) that features after-tax contributions, tax-deferred growth (meaning you’ll only pay taxes on the amount earned whenever you withdraw funds), and the ability to contribute significantly more than the IRS allows for a standard 401(k). As employer-sponsored Roth 401(k) and after-tax plans are less common overall, we’ll zero in on traditional 401(k) plans unless otherwise noted throughout the remainder of this article.

401(k) enrollment

Most employers have a 401(k)-contribution waiting period that varies from one organization to another, though some do offer immediate eligibility. Existing 401(k) plans are typically grandfathered in, but many new employer plans automatically enroll employees—meaning anyone not interested in participating must proactively opt out. Automatic enrollment also includes a default contribution rate of at least 3% of one’s salary, which increases by 1% annually until it reaches at least 10%.

401(k) contributions

401(k) contribution limit	2025	2026
Employee deferral (under 50)	$23,500	$24,500
Catch-up (age 50+)	$7,500	$8,000
"Super" catch-up (ages 60–63)	$11,250	$11,250
Employee + employer combined	$70,000	$72,000

The IRS sets annual limits on how much you can contribute to a 401(k), and they generally rise a bit each year. For 2026, employees under age 50 can contribute up to $24,500 (up from $23,500 in 2025). Those 50 and older can add a catch-up contribution of $8,000 (up from $7,500), and a higher "super catch-up" of $11,250 applies to those ages 60–63. Employee and employer contributions combined are capped at $72,000 for 2026, not counting catch-up contributions, which can push the total higher.

A rule under SECURE 2.0 also took effect in 2026: if your wages from your employer topped $150,000 the prior year, any catch-up contributions must go into a Roth (after-tax) version of your plan rather than pre-tax. You'll pay tax on that catch-up money up front, but neither it nor its earnings will be taxed when you withdraw later. If your employer doesn't offer a Roth option, affected high earners can't make catch-up contributions at all.

New For 2026

High earners: catch-ups must now be Roth

Under a SECURE 2.0 rule that took effect in 2026, if your prior-year wages topped $150,000, any catch-up contributions have to go into the Roth (after-tax) side of your plan.

If your 2025 wages were

Over $150,000

→

Your 2026 catch-up must be

Roth (after-tax)

→

The upside

Tax-free growth & withdrawals

⚠ If your plan has no Roth option, affected high earners can't make catch-up contributions at all. Worth confirming with your plan before the year gets away from you.

You'll pay tax on the catch-up up front, but that money and its earnings come out tax-free later. 2026 rule; Source: IRS / SECURE 2.0. Not individual tax advice.

401(k) benefits

The Big Advantage

Four tax perks of a 401(k)

✓Pre-tax contributions

Funded with pre-tax dollars, so you don't owe tax until you withdraw.

✓Lower taxable income

Contributions shrink the income you're taxed on—possibly dropping your bracket.

✓Tax-deferred growth

Gains compound untaxed as long as you don't withdraw early.

✓ERISA protection

Your account is generally shielded from creditors under federal law.

How it lowers your taxable income

Earn $100,000 · contribute $15,000 → only $85,000 is taxed

Illustrative example; a Roth 401(k) works differently—no deduction now, but tax-free withdrawals later. Not individual tax advice.

Corresponding tax benefits are the most significant advantage of 401(k) ownership. First and foremost, contributions are tax-deferred as the account is funded with pretax dollars: meaning you won’t pay taxes on this until you make a withdrawal. Next, because contributions are made with pretax dollars, they lower your taxable income (e.g., if you earn $100,000 a year and contribute $15,000 annually, only $85,000 is subject to tax); your 401(k) contributions can thus ultimately drop you into a lower tax bracket. Tax-deferred growth is another benefit, as any 401(k) balance gains grow tax-deferred provided you don’t make a withdrawal before hitting the minimum age requirement (more on that later). Finally, your 401(k) is protected by ERISA (the Employee Retirement Income Security Act of 1974), protecting your account from creditors.

401(k) drawbacks

As with any retirement account, some drawbacks do exist with respect to 401(k) plan investments including account fees, limited investment options, and early withdrawal fees. Let’s discuss each of these in more detail…

401(k) fees

Watch Your Statements

The fees quietly eating your returns

401(k) fees are deducted directly from your returns, so they're easy to miss—but they add up over decades.

Typical total fees

0.5% – 2% of plan assets per year

Investment fees

Often the largest—the cost of managing your funds, pulled from returns.

Administrative fees

Plan upkeep, statements, and service. Employers sometimes cover these.

Individual service fees

Charged only when you use a feature—like taking a 401(k) loan.

Check your statements and compare fund expense ratios where you have a choice—small percentages compound into real money over a career. General information, not individual advice.

401(k) plan providers charge fees that typically range from 0.5% to 2% of total plan assets and often fall into three categories: administrative, investment, and individual service fees. Often the most expensive, investment fees cover investment management costs and are deducted directly from investment returns—so pay close attention to your statements! Administrative costs, meanwhile, cover plan maintenance expenses (e.g., account access and statements) and customer service fees. Employers do sometimes cover these, but they’re otherwise paid by plan participants themselves and are also automatically deducted from returns. Keep in mind service fees are specific to each employee and charged for plan features/actions (e.g., taking out a loan).

Early withdrawal fees

Although some exceptions do exist (which we’ll get into shortly), those looking to make a withdrawal before the age of 59½ are subject to a 10% early withdrawal penalty from the IRS and also required to pay taxes on the withdrawal—assuming their employer even allows this. You can withdraw money from your 401(k) without paying an early withdrawal penalty starting at this same age, however, though the amount is considered income and consequently subject to taxes.

Limited investment options

Compared to other retirement accounts such as an IRA or taxable brokerage account, 401(k)s sometimes have fewer investment options—which some participants view as beneficial as it organically minimizes complexity. That said, your menu may widen over time: following a 2025 executive order, the Department of Labor proposed a rule in March 2026 that would make it easier for 401(k) plans to offer alternative assets such as private equity and real estate. The rule isn't final — and these investments tend to carry higher fees, less liquidity, and more complexity — so proceed carefully if your plan eventually adds them.

401(k) withdrawal options prior to age 59½

Before Age 59½

Six ways to tap a 401(k) penalty-free

Withdrawals before 59½ usually trigger a 10% penalty plus taxes—but these routes can avoid the penalty.

1.The rule of 55

Leave a job at 55–59½ and withdraw penalty-free—but only from your most recent employer's plan.

2.401(k) loans

Borrow up to $50,000 or 50% of your balance (whichever is less), typically repaid within 5 years.

3.Special circumstances

An IRS levy, death (to a beneficiary), or a court order to a spouse, child, or dependent.

4.Hardship withdrawals

For an “immediate and heavy” need, if your plan allows—still taxed, so a last resort.

5.SEPP plans

A fixed series of payments for the longer of 5 years or until 59½—only from a former employer's plan.

6.Emergency distribution

Withdraw up to $1,000 penalty-free, with the option to repay over 3 years.

Most of these still owe ordinary income tax—they only skip the 10% penalty. Rules and eligibility vary by plan; confirm with your HR department. General information, not individual advice.

Keep in mind you can rely on a few specific strategies to potentially avoid the 10% early withdrawal penalty on your 401(k). These include:

The rule of 55

If you lose or leave a job and are between the ages of 55 and 59½, the rule of 55 allows you to withdraw funds from your 401(k) account without penalty—but only applies to the 401(k) with your most recent employer.

401(k) loans

Most 401(k) plans allow you to access a portion of your retirement plan money (usually up to $50,000 or 50% of your assets, whichever is less) on a tax-free basis, with most employers permitting you to borrow from your 401(k) for any reason as well. Should you decide to do this, you’re required to pay back these loans (often within five years), and payments are generally deducted from your paycheck. If you borrow money and then lose your job or change employers, however, the outstanding balance is generally treated as a "loan offset"—and you typically have until your federal tax-filing deadline (including extensions) for that year to repay or roll over the amount into an IRA or another qualified plan to avoid having it taxed as a distribution (plus a potential 10% early withdrawal penalty if you're under 59½).

Special circumstances

The IRS does allow penalty-free withdrawals under special circumstances including IRS payments due to a levy, following the death of a participant (with money going to a beneficiary), or under a court order to direct money to a divorced spouse, child, or dependent.

Hardship withdrawals

If you need to withdraw a significant amount of money to meet an “immediate and heavy financial need,” you can potentially avoid the early withdrawal penalty provided your employer offers hardship withdrawals and you qualify with the IRS; expenses that meet such criteria often include a sudden disability or medical expense debt exceeding 7.5% of your adjusted gross income. Should you find yourself in one of these situations, be sure to check with your HR department to determine if your circumstances qualify for a hardship withdrawal. Keep in mind that hardship withdrawals are still subject to income tax and, if you're under 59½, generally the 10% early withdrawal penalty—so they should be considered a last resort.

Substantially equal periodic payment (SEPP) plans

SEPP plans allow you to receive a series of annual payouts from your 401(k) for either 5 years or until you reach age 59½—whichever occurs later. You aren't allowed to make any other distributions from your 401(k) during this window, and the decision to cease any scheduled annual payouts will trigger an early withdrawal penalty. Also keep in mind you can only set up a SEPP program for a 401(k) plan with an employer you no longer work with.

Emergency distributions

You can withdraw up to $1,000 without penalty as an emergency distribution, with the option to repay this over a span of 3 years (or fewer). Keep in mind, however, that other distributions aren’t allowed during this same period or until the money is repaid.

For the full rundown of the rules governing each type of withdrawal, see our guide to 401(k) withdrawal rules.

Required minimum distributions (RMDs)

When required minimum distributions kick in

Eventually the IRS makes you start withdrawing from a traditional 401(k)—so it can finally collect the tax.

RMDs begin at

73

For most people today.

Born in 1960 or later?

75

The age rises to 75 starting in 2033.

Penalty for missing one

25%

Of the amount you should have withdrawn.

Roth 401(k)s and Roth IRAs work differently—Roth IRAs have no RMDs during your lifetime. Withdrawals are taxed as ordinary income; you can always take more than the minimum. General information, not individual tax advice.

Generally speaking, you’re required to withdraw a minimum amount of money from your 401(k) when you turn 73 (climbing to 75 in 2033). This stipulation is referred to as RMDs (required minimum distributions) and also applies to all other employer-sponsored retirement plans including 403(b)s, traditional IRAs, and IRA-based plans. The reason for the requirement? It’s simple: Uncle Sam wants you to pay taxes on these assets. You can always withdraw more than the minimum amount required for RMDs, though tax implications may arise as the amount is taxed as ordinary income, and can face a hefty penalty if you fail to take your RMD by the deadline—perhaps making you liable for a fee equal to 25% of the amount you didn’t take (or otherwise took in excess).

What happens to your 401(k) when you leave a job?

Four things you can do with an old 401(k)

When you leave a job, you'll usually have at least 30 days to pick a path. Three keep your money invested; one rarely makes sense.

Leave it with your old employer

Fine if the old plan has better options—but it's one more account to manage, and you can't add to it. Usually needs a ~$7,000 minimum balance.

Keeps growing

Roll into your new 401(k)

Consolidates accounts and can help the rule of 55 later—if the new plan accepts rollovers and you like its options.

Keeps growing

Roll into an IRA

Often the best fit—nearly unlimited investment choices and one home for savings across jobs. Traditional or Roth, your call.

Keeps growing

Cash it out

Almost always the worst option: income tax on the full amount, a 10% penalty if under 59½, and lost years of growth.

Costly

Check your vesting schedule first—you may be days from a cliff that unlocks more of the employer match. General information, not individual advice.

This is one of the biggest 401(k) decisions you'll make — we walk through each path in depth in our guide to your 401(k) options when switching jobs. After leaving a job, you’ll typically have at least 30 days to choose one of the following options:

Leave your savings with your current employer

Most companies will allow you to keep your retirement account right where it is provided you maintain a minimum account balance (typically $7,000). This course of action means you can no longer contribute to this retirement plan, which will exist separate from any plans offered by your new employer as one more account to manage—a decision often worth it if your former employer's plan offers better options than those available at your new company.

Roll over your savings into your new employer’s 401(k) plan

Rolling over your 401(k) is often a good choice provided you're satisfied with the investment options, costs, and features offered by your new employer-sponsored plan; you'll also enjoy an opportunity to consolidate retirement plans, giving you one fewer account to manage. Another benefit? If you retire or lose your job between age 55 and 59½, you can withdraw funds (from your most recent employer’s plan) without incurring any early withdrawal penalties per the rule of 55; the more money you have in your most recent 401(k) plan, the more money can access under this rule. A key caveat? You’ll need to confirm your new employer’s 401(k) plan accepts rollovers.

Roll over your savings into an IRA

For most people, rolling a 401(k) into an individual retirement account (IRA) is often their best bet as IRAs offer nearly unlimited investment options whereas employer-sponsored 401(k) choices are more restricted. With an IRA, you can invest your savings in any manner you’d like whether via real estate or stocks, bonds, mutual funds, and/or ETFs. You can even select from a Roth IRA or traditional IRA—the choice is yours! Keep in mind, however, that tax implications are sometimes involved depending on your own individual circumstances. If you plan on changing jobs at least a few times over the remainder of your career, an IRA can serve as a single platform for your previous retirement savings plans.

Cash out your savings

While it’s perhaps tempting to withdraw all of your cash as a bonus (referred to as a “lump-sum distribution”), this is almost always your worst option as you'll owe income tax on the amount withdrawn. Moreover, anyone under the age of 59½ is also subject to the aforementioned 10% early withdrawal fee while losing out on precious time for savings growth.

Vesting schedules

No matter which path you choose, know you may not be entitled to all the monies in your retirement account as many employer-sponsored retirement plans follow a vesting schedule dictating employees stay with the company for an extended period to realize the full value of employer-matching contributions. With this in mind, take time to investigate your company’s vesting schedule; you may learn you’re mere days or weeks away from the next vesting cliff. In this case and if at all possible, it’s perhaps worth staying put a little longer.

Actions to take if your 401(k) balance seems too volatile

A Rough Rule of Thumb

The “rule of 100” for your stock mix

A quick gauge of how aggressive a portfolio to hold—subtract your age to estimate your stock percentage.

100 − your age = % in stocks

Age 40

60% stocks
40% bonds / CDs

Age 55

45% stocks
55% bonds / CDs

Age 70

30% stocks
70% bonds / CDs

Because people live longer, some experts subtract from 110 (or more) to keep enough growth. It's a starting point, not a personalized allocation—and it can flag when you're invested too conservatively, too. General information, not individual advice.

If your 401(k) account balance fluctuates more than you’d like—especially during market downturns—there’s a chance you’re investing too aggressively. In these situations, you (or your financial advisor) may need to reassess and readjust your risk tolerance, meaning your ability and willingness to stomach large swings in the value of your investments.

The higher the risk tolerance, the more likely your portfolio will include riskier investments such as stocks. A lower risk tolerance, meanwhile, could see more stable investments in your portfolio such as bonds or certificates of deposit (CDs). Failing to ignore risk tolerance in your 401(k) investment strategy is often a recipe for panic and can prompt an emotional reaction during market downturns, causing you to sell at the wrong time.

The “rule of 100” comes into play here as a tool commonly used to gauge—at a high level—aggressiveness, dictating the proportion of stocks within any given portfolio. Using this strategy, you simply subtract your current age from 100 to learn which percentage of your investments to keep in stocks with safe assets (e.g., bonds and CDs) comprising the remainder. Keep in mind this rule isn’t for everyone as individual circumstances vary and that due to longer life expectancies, some experts have modified it to subtract any given age from 110 (or more!) to ensure you don’t run low on funds. The rule can also indicate the reverse—that you’re investing too conservatively.

When investing, remember it’s okay to feel a little uncomfortable amidst market downturns as you’ll need some level of exposure to stocks; while stocks are often very volatile, they’re also one of the best ways to grow wealth over time. If your portfolio is too conservative, likewise, it’s perhaps not well-suited to meet your long-term goals.

The importance of 401(k) rebalancing

How rebalancing keeps you on target

Say your target is 60% stocks / 40% bonds. Over time, a strong market pushes stocks higher than you intended.

Your target

60%

40%

The mix that fits your goals and risk tolerance.

→

Market drift

70%

30%

Stocks grew—now you're carrying more risk than planned.

→

Rebalanced

60%

40%

Sell some stocks, buy bonds—back to target.

Rebalancing has you sell high and buy low by design—trimming what's grown and adding to what's lagged. Illustrative; your target mix is your own. General information, not individual advice.

Whether you’re investing on your own or working with a financial advisor, you’ll need to nail down an “asset allocation”: the preferred percentage of stocks, bonds, etc., in your 401(k) based on your goals, risk tolerance, and investment time horizon (aligning with both your needs and temperament). An established target allocation requires ongoing maintenance, as market values fluctuate over time alongside the value of your investments, and calls for rebalancing: the act of adjusting (buying and selling) investments to restore your portfolio’s allocated percentages to their original makeup and the most common tool used to do so.

Let’s assume your desired asset allocation reflects 60% stocks and 40% bonds and that, over time, market fluctuations shift this allocation to 70% stocks and 30% bonds. In this case, your financial advisor would simply rebalance your portfolio to return your current investment allocations to their original percentages—selling investments that have increased in value (selling high) while buying others that have decreased but still have merit (buying low). This process also optimizes the overall value of your portfolio.

The bottom line on 401(k)s

401(k)s provide an easy way to kickstart the retirement savings process, especially since owning an account comes with several tax advantages. As many employers also match a portion of your savings, there’s simply no reason not to open a 401(k) account if you’re eligible. A few related guides worth a look: if your pay also includes equity compensation, if you have a 403(b) rather than a 401(k), if you've inherited a 401(k), or if you want to avoid the biggest 401(k) mistakes.

Still have questions about 401(k)s? Schedule a FREE discovery call with one of our financial advisors to get them answered.

Reviewed for accuracy

Benjamin Stark, CFP®

Financial Advisor and Director of Client Experience at Vision Retirement, with 10+ years as a financial advisor.

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FAQs

• How much should I contribute to my 401(k)?

  While no “magic number” exists in this case, make sure you’re—at a minimum—maximizing your potential employer match as missing out means leaving money on the table! Read our article to learn more about how much to contribute.

• What happens if I overcontribute to my 401(k)?

  If you overcontribute to your 401(k), the first step is to contact your plan administrator and inform him/her about the situation; the sooner you address the issue, the fewer penalties you’ll face. If you correct the error before the tax deadline (e.g., by April 15, 2026 for excess 2025 contributions), you can file your taxes using an updated W-2 but must still pay taxes on the overcontribution and any earnings generated from that amount (considered income for that year). If you miss the deadline, you may face double taxation—once in the year you overcontributed and again in the year you withdraw the excess—as well as a 10% early withdrawal penalty on that amount.

• Can I have both an IRA and 401(k)?

  It’s a common misconception that one must choose solely between a Roth IRA and 401(k). This isn't necessarily the case! You can indeed strategically use both accounts to amplify your retirement savings.

• How much can I contribute to a 401(k) in 2026?

  For 2026, employees under 50 can contribute up to $24,500. Those 50 and older can add an $8,000 catch-up (or $11,250 at ages 60–63), and combined employee-plus-employer contributions are capped at $72,000.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.