What is a 401(k) and how does it work?

A 401(k) is a retirement savings account offered through your employer that takes money directly out of your paycheck before you ever see it, invests it, and often comes with free matching money from your employer. It's one of the most common ways Americans save for retirement, largely because of that match and the payroll-deduction convenience.

How contributions work

The takeaway: you choose a percentage of each paycheck to contribute, and it's deducted automatically before you receive the rest.

• You select a contribution percentage or dollar amount through your employer's plan portal.
• That amount is deducted from each paycheck automatically — no separate transfer or manual saving required.
• You choose how the contributions are invested, usually from a menu of mutual funds, target-date funds, or index funds offered by the plan.
• Contributions and any investment growth are not taxed as they accumulate in a traditional 401(k) — tax is deferred until withdrawal.

The employer match

The takeaway: many employers add money on top of your contribution, and not taking it is like leaving part of your pay on the table.

A typical structure is something like "50% of what you contribute, up to 6% of your salary" — the specifics vary widely by employer. Common match formats:

Match style	Example
Full match to a cap	100% match on the first 3% of pay you contribute
Partial match to a cap	50% match on the first 6% of pay you contribute
No match	Some plans offer no employer contribution at all

Traditional vs Roth 401(k)

The takeaway: the difference is when you pay income tax, not whether you pay it.

• Traditional 401(k): contributions are made pre-tax, reducing your taxable income now; withdrawals in retirement are taxed as ordinary income.
• Roth 401(k): contributions are made with money that's already been taxed; qualified withdrawals in retirement, including investment growth, are generally tax-free.
• Many plans let you split contributions between both types.
• The employer match itself is typically deposited into a traditional (pre-tax) bucket even if your own contributions go into a Roth 401(k), so that portion is taxed on withdrawal regardless of your choice.

Vesting only applies to the employer's contributions — money you contribute yourself is always 100% yours immediately.

Vesting schedules

The takeaway: your own contributions are always fully yours; the employer match may not be until you've worked there long enough.

Common vesting structures:

• Immediate vesting — the match is yours right away.
• Cliff vesting — you own 0% of the match until a specific milestone (e.g., 3 years), then 100% all at once.
• Graded vesting — you own an increasing percentage each year (e.g., 20% per year over 5 years) until fully vested.

Leaving a job before you're fully vested typically means forfeiting the unvested portion of employer contributions, though your own contributions and any vested match stay with you.

Contribution limits

The takeaway: the IRS sets an annual cap on how much can go into a 401(k), and it's adjusted periodically, generally upward, to account for inflation.

• There's an annual employee contribution limit that applies to your own traditional plus Roth contributions combined.
• A separate, higher combined limit applies when employer contributions (the match) are included.
• Catch-up contributions allow employees age 50 and older to contribute an additional amount above the standard limit.
• Because these figures are adjusted periodically, check the current IRS limit directly rather than relying on a number that may be out of date.

Rollovers: what happens when you change jobs

The takeaway: vested 401(k) money doesn't disappear when you leave a job — you generally have a few options.

• Leave it in the old employer's plan, if the plan and balance allow it.
• Roll it into your new employer's 401(k), consolidating accounts.
• Roll it into an IRA, often widening your investment choices beyond the employer plan's menu.
• Cash it out — generally the least favorable option, since it typically triggers income tax and, if you're under 59½, an early withdrawal penalty.

A direct rollover avoids tax withholding; an indirect rollover (funds paid to you first) has strict 60-day rules and a mandatory withholding that can create tax complications if not handled carefully.

Common mistakes

• Leaving contributions at the plan default, which is often lower than what's needed to capture the full match.
• Never revisiting the investment selections, leaving money in an overly conservative or overly aggressive default fund for years.
• Cashing out a small balance when changing jobs instead of rolling it over, which usually triggers taxes and penalties.
• Ignoring fees. 401(k) plans vary in the fund fees charged; lower-cost index or target-date options within the plan are often preferable when available.
• Not increasing contributions with raises, letting the savings rate slowly fall behind income growth.

A worked example

This is illustrative only. Consider a hypothetical employee earning $60,000 a year whose employer matches 50% of contributions up to 6% of pay. Contributing 6% ($3,600) draws a $1,800 employer match — a combined $5,400 going into the account for a $3,600 outlay. Contributing less than 6% means giving up part of that match; contributing more increases personal savings but doesn't increase the match beyond the 6% cap.