401(k)

Quick Definition

A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their pre-tax salary into investment accounts, reducing their taxable income today while building tax-deferred wealth for retirement. The name comes from the section of the Internal Revenue Code that governs it.

What It Means

The 401(k) is the backbone of private-sector retirement savings in the United States. Before 401(k) plans became widespread in the 1980s, most workers relied on pension plans where employers guaranteed a fixed monthly payment in retirement. Today, the 401(k) shifts that responsibility largely onto the employee.

Contributions go in before federal and state income taxes are calculated. If you earn $70,000 and contribute $7,000 to a 401(k), you only pay income tax on $63,000 that year. The investments grow tax-deferred, meaning you pay no tax on dividends, interest, or capital gains inside the account while they compound. You only pay income tax when you withdraw money in retirement, at which point your tax rate is often lower.

How It Works

Step-by-Step Process

1. Enroll through your employer's HR department or benefits portal
2. Choose your contribution percentage of each paycheck (e.g., 6% of salary)
3. Select your investments from the menu your employer's plan offers (typically mutual funds, ETFs, and target-date funds)
4. Contributions are deducted automatically from each paycheck before taxes
5. Investments grow tax-deferred over time through compound interest
6. Your employer may match a portion of your contributions
7. Withdraw in retirement (age 59.5+) and pay ordinary income tax on withdrawals

2026 Contribution Limits

The IRS raised contribution limits for 2026. According to IRS Notice 2025-67, the new limits are:

New for 2026: Mandatory Roth Catch-Up for High Earners

Starting January 1, 2026, a SECURE 2.0 provision takes effect that requires catch-up contributions to be made on a Roth basis for participants who earned more than $150,000 in FICA wages from the plan sponsor in the prior year (2025). The $150,000 threshold is the inflation-indexed figure for 2026, up from the statutory base of $145,000.

If your plan does not offer a Roth option, high-earning participants cannot make catch-up contributions at all. Plans without a Roth feature will need to add one or block catch-ups for affected employees.

The Employer Match: The Most Important Number

The employer match is the most powerful feature of a 401(k). It represents an immediate, guaranteed 50 to 100% return on your investment. No asset class reliably delivers that.

How Matching Works

A common match formula: 100% of contributions up to 3% of salary, plus 50% of contributions from 3 to 5% of salary.

Always contribute at least enough to get the full employer match. Not doing so is leaving a portion of your compensation on the table.

Vesting Schedules

Employer match contributions may not be immediately yours. Most employers use a vesting schedule:

Your own contributions are always 100% vested immediately. The vesting schedule only applies to employer contributions. Leaving a job before you are fully vested means forfeiting unvested employer contributions.

The Power of Tax-Deferred Growth

Scenario: You contribute $500/month to a 401(k) vs. a taxable account, both earning 7% annually, over 30 years. Assume a 24% marginal tax rate.

The 401(k) wins by roughly $86,000 in this example, purely from the tax-deferred compounding advantage and the upfront tax savings.

Investment Options

Most 401(k) plans offer a limited menu of investment options selected by your employer:

Target-date funds are the simplest option: pick the fund closest to your expected retirement year (e.g., "Target 2055 Fund") and it automatically becomes more conservative as you approach retirement. Pay attention to the expense ratio of whatever you choose, since fees compound into large differences over 30 years.

Traditional 401(k) vs. Roth 401(k)

Many employers now offer both options:

If you are early in your career and in a low tax bracket, lean toward the Roth 401(k). If you are a high earner in your peak earning years, the traditional pre-tax 401(k) gives you a bigger tax break now. You can also split contributions between both.

Withdrawals, Penalties, and Required Minimum Distributions

Early Withdrawal (Before 59.5)

Withdrawing before age 59.5 triggers a 10% early withdrawal penalty on top of ordinary income tax. On a $20,000 withdrawal at a 22% tax rate:

• Income tax: $4,400
• Penalty: $2,000
• Total cost: $6,400 (32% of the withdrawal)

Exceptions to the penalty include disability, certain medical expenses, substantially equal periodic payments (SEPP/72(t)), and certain first-time home purchases (in Roth 401k only).

Required Minimum Distributions (RMDs)

Starting at age 73, the IRS requires you to begin taking minimum withdrawals from a traditional 401(k) whether you want to or not. The RMD amount is calculated by dividing your account balance by a life expectancy factor from IRS tables.

Failing to take your RMD results in a 25% excise tax on the amount you should have withdrawn (reduced to 10% if corrected promptly).

Real-World Example: The Cost of Not Contributing

Two colleagues, both earning $65,000, both age 25:

• Alex contributes 6% ($3,900/year) with a 3% employer match ($1,950/year). Total: $5,850/year.
• Jordan contributes nothing, spending the extra $3,900/year.

At age 65, assuming 7% average annual return:

Jordan would need to save an extraordinary amount in taxable accounts to match what Alex built through consistent, employer-matched, tax-deferred contributions.

Key Points to Remember

• Always get the full employer match first before any other investment decision
• The 2026 employee contribution limit is $24,500, or $32,500 with catch-up (age 50+), or $35,750 for ages 60-63
• Contribution limits reset every January 1; you cannot contribute extra to make up for prior years
• Investment selection matters enormously over 30-40 years; low-cost index funds typically outperform actively managed funds
• Leaving a job means you can leave the 401(k) with the old employer, roll it to a new employer's plan, or roll it to an IRA
• Loans from 401(k) are allowed by most plans but risky; if you leave the job, the loan may become due immediately
• Starting in 2026, high earners (over $150,000 in prior-year FICA wages) must make catch-up contributions as Roth

Common Mistakes to Avoid

• Not contributing enough to get the full match: This is the single most common and costly mistake. You are turning down free money.
• Cashing out when changing jobs: Rolling over to an IRA or new employer's plan avoids taxes and penalties.
• Ignoring investment selection: Leaving money in a default money market fund for decades destroys long-term returns.
• Not increasing contributions after raises: Automate contribution increases each year.
• Borrowing from your 401(k): Loans interrupt compounding and create risk if you leave the job.
• Missing the Roth catch-up rule change: If you earned over $150,000 in 2025 FICA wages, your 2026 catch-up contributions must go into a Roth account. Check with your plan administrator.

Frequently Asked Questions

Q: What happens to my 401(k) if my employer goes bankrupt? A: Your 401(k) assets are legally separate from the company's assets and are held in a trust. If your employer goes bankrupt, creditors cannot touch your 401(k) balance. The plan assets belong to you.

Q: Can I contribute to both a 401(k) and an IRA? A: Yes. You can max out a 401(k) and also contribute to a Roth IRA or traditional IRA in the same year, subject to IRA income limits and contribution caps. The 2026 IRA limit is $7,500 ($8,600 if age 50+).

Q: What is a "safe harbor" 401(k)? A: A safe harbor plan is designed to automatically pass certain IRS non-discrimination tests. Employers typically must make mandatory contributions to all eligible employees. These plans are common at smaller businesses.

Q: How do I find out what investments my plan offers? A: Log into your plan's website (administered by Fidelity, Vanguard, Empower, or similar) and look under "investment options" or "fund lineup." Compare expense ratios and historical performance there.

Q: I earned over $150,000 in 2025. What does the new Roth catch-up rule mean for me? A: Starting in 2026, all your catch-up contributions must be designated as Roth (after-tax). You can still contribute up to the regular $24,500 limit on a pre-tax basis. Only the catch-up portion (the extra $8,000 or $11,250) must go into Roth. Check that your plan offers a Roth option.