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

What is a 401(k)? Why is it so special?

A 401(k) is a tax-deferred investment account that allows employees to contribute a specific amount of their salary to be saved for retirement. The money an employee puts away into an account is an investment in the market, made up of mutual funds, stocks, bonds, money market funds, savings accounts, and other investment options. It is subject to investment risk, meaning it can gain or lose value based on one’s investment choices.

The purpose of a 401(k) plan is to help ensure people can save for retirement. However. research indicates that only one-third of working Americans feel adequately prepared for retirement. The Employee Benefit Research Institute estimates that Americans need to save an additional $3.68 trillion to achieve their retirement goals. While many contributing factors can prevent someone from having enough money to save for retirement, a 401(k) account is designed to encourage people to save as much as they can.

A 401(k) plan must be sponsored by an employer because these tax-deferred plans are specifically set up to help businesses encourage their employees to save for retirement. While employees are the participants in the plan, they cannot set up a 401(k) plan of their own (unless they sponsor a Solo(k) as a self-employed individual).

Why is my employer offering a 401(k)?

A 401(k) is attractive to employers for several reasons:: 

• Employees can benefit from the tax advantages of a 401(k) – and so do employers. 

• The IRS gives eligible employers tax credits for starting a 401(k) plan and/or tax deductions if an employer contributes to their employee’s 401(k)s.

• Employers can increase their chances of hiring and retaining talent. According to a Human Interest study, a retirement plan is the second most wanted benefit after health insurance. 

What are the benefits of a 401(k)?

The primary benefit of a 401(k) plan is helping employees save for retirement. However, two additional benefits entice employees to contribute to a 401(k): potentially receiving a contribution from an employer and reducing taxable income for the year. 

When an employer chooses to contribute a match to their employee’s 401(k) accounts, a match is given to employees who defer into the plan and is calculated based upon the amount an employee defers into the plan from their paycheck. Employers may also choose to contribute a profit-sharing contribution to employees, which is not dependent on deferrals.

Matching contribution example

An employee contributes $5,000 (or 5% of their salary) to their 401(k) account, and their employer matches $0.50 per dollar on the first 5% an employee defers. The employee would receive $2,500 ($5,000 x 50%) in matching funds, just for deferring into the plan. Now, the employee has $7,500 in total contributions for the year. 

A profit-sharing contribution does not require an employee to defer into the plan to receive it, but the plan document could set other requirements that the employee must meet annually to receive the contribution, such as employment on the last day of the plan year.

The second benefit is the reduction of taxable income in the year of deferral. Traditional (pre-tax) deferrals are deducted before income taxes are withheld from pay and are taxed upon withdrawal (which is usually later in life). This could result in significant tax savings at year-end.

Taxable income example

Let's look at a quick example to illustrate the benefits of contributing to a 401(k) plan. A participant earns $100,000 per year. They are 27 years old, single, have no dependents, and will be taking the estimated standard deduction of $14,600 for 2025.¹

The immediate tax benefit of contributing the estimated maximum amount allowed by law to a 401(k) in 2025 is an estimated $5,250 in tax savings. This represents approximately a 59.4% reduction in estimated federal taxes.

How does a 401(k) work?

401(k)s are defined contribution plans. This means that employers create a retirement plan that allows employees to contribute money (otherwise known as a deferral) on a pre-tax basis up to a limit set by the IRS. The money deposited into an employee’s account is then invested in their investment elections. 

What is the contribution limit for 401(k)s?

For 2025, the maximum deferral contribution limit as set forth by the IRS is $23,500. The catch-up contribution limit for those participants who will be 50 years or older in the calendar year is $7,500, and $11,250 for ages 60-63. These limits change annually depending on COLA adjustments. Business owners—who can contribute as both an employee and employer—have a higher contribution limit when factoring in employer contribution limits (subject to annual non-discrimination testing, as applicable).

What types of 401(k) deferrals are there? 

There are two types of deferrals allowed in 401(k) plans. Traditional, or pre-tax, and Roth, or post-tax deferrals. Roth deferrals are not a required 401(k) plan provision, but many employers provide the option.

If you have trouble choosing between the two types of deferrals, you may want to consider two points: 

• A traditional 401(k) deferral may be best if you expect your tax bracket will be lower when you retire. If so, your withdrawals at retirement will be subject to a lower tax bracket when withdrawn.

• A Roth 401(k) deferral may be best if you expect your tax bracket will be higher when you retire. Assuming this to be the case, your withdrawals at retirement will be tax-free, and would have been taxed at the lower rate assessed when originally deferred into the plan.

You can work with a financial advisor to forecast whether you expect to be in a lower or higher tax bracket during retirement to make an informed decision on what type of 401(k) deferral is right for you.

Remember that tax rates could rise in the future and, even if they don't, it is nice to have some money in retirement that has already been taxed. A Roth 401(k) can be a sensible choice for high-income earners seeking a post-tax retirement savings tool. However, for higher earners, the only way to access a Roth contribution may be through an employer-based plan since Roth individual retirement accounts (Roth IRAs) have contribution limits based on income.

401(k) features: auto-enrollment, auto-escalation, vesting schedules

Every 401(k) plan may come with different features depending on your employer. Here are a few of the most common features of 401(k) plans. 

1. Automatic enrollment 

Automatic enrollment allows an employer to sign an employee up to participate in the company’s 401(k) plan unless they choose to opt out. Newly eligible employees who don’t opt out of plan participation will have a default percentage of compensation contributed pre-tax to their plan from each paycheck. Employers set the default election in the plan document. The plan sponsor or 401(k) custodian can be contacted to opt out of the automatic enrollment process or to change a deferral election.

Beginning with the 2025 plan year, auto-enroll and auto-escalation are now required for new plans started after 12/29/22.

2. Auto-escalation 

Auto-escalation refers to a plan provision where an employee’s deferral election is increased on a regular basis, usually annually in 1% increments. The plan sponsor or 401(k) custodian can be contacted to opt out of the automatic escalation process or to change a custom deferral election.

3. Vesting schedule

A vesting schedule establishes what percentages of employer contributions an employee owns as they continue employment with the plan sponsor. Even though the employer may make contributions during a specific pay period, many employers offer vesting schedules to incentivize longer-term employment by offering partial ownership over time. There are three types of vesting schedules, and each type and rate varies by employer:

• Immediate vesting: Employees own 100% of the employer contributions immediately.

• Graded vesting: Employees own a growing percentage of employer contributions over time. For example, an employee may own 25% of an employer's contributions after one year of employment, 50% after two years, and so on. Documents must provide for vesting of at least 20% of the contributions by the end of two years and 100% by the end of six years.

• Cliff vesting: Under this schedule, documents must fully vest employer contributions by the end of three years of employment, and there are no progressive levels of vesting.

Vesting schedules must be clearly explained in the employer’s 401(k) plan document. Click here to learn more about 401(k) vesting schedules.

401(k) FAQs

How much do people put in their 401(k) per year?

With data from nearly 5 million participants, Vanguard's 2024 How America Saves report showed an average employee contribution rate of 7.4% for 2023. 

Do most people get an employer match?

Yes. According to a Plan Council of America Survey, 98% of 401(k) plans offer an employer match or a profit-sharing contribution. 

What's the typical vesting schedule for an employer match?

According to Vanguard's 2024 How America Saves, nearly 50% of plans administered by Vanguard with employer contributions immediately vested participants. Nearly 25% of plans with employer-matching contributions used a 5- or 6-year graded vesting schedule, and about 17% of participants with employer-matching contributions were in such a plan.

What's the average 401(k) balance?

According to Vanguard's 2024 How America Saves, the average 401(k) balance is a median balance of $38,176.

Does my employer have to match? 

A matching contribution from your employer is not required. That said, many employers do offer a match, and they also choose the formula that will determine how much they contribute to your 401(k) plan. 

Limits for high-income earners

As determined by the IRS, employees whose annual income or percentage ownership in the company meets a specific threshold may only contribute a portion of their earnings. If you own more than 5% of the business offering the 401(k) plan (or are a family member of someone who does) or earn a certain amount in the prior year as determined by regulations, you may be subject to a refund depending on nondiscrimination testing results each year.

If you also plan to contribute to an IRA

If you have access to an employer-sponsored retirement savings plan, such as a 401(k), your modified adjusted gross income will determine how much - if any - of a tax deduction you’ll get for IRA contributions.

401(k) and special circumstances

There are many times when you may have special circumstances regarding a 401(k). Let’s review some of those below. 

You change jobs

If you decide to work for a new employer, you have a few options regarding what you can do with your 401(k). Assuming you’re not ready to withdraw, you can choose to roll over your 401(k) into a new account (if applicable) or IRA, rather than cashing out (and being penalized for early withdrawal if under age 59 ½). You can also decide to leave it with your former employer if it exceeds the cashout limit of the plan (either $1,000 or $7,000) 

You have multiple 401(k)s

Having multiple 401(k) accounts is allowed, even concurrently contributing to more than one, as long as you don’t exceed the annual deferral contribution limit (you will also need to be employed by multiple companies if you plan on contributing to more than one plan). 

You need the money before retirement 

Since a 401(k) is a retirement account, the rules make it hard to take money out before age 59 ½. It’s important to note that if you take out money in cash before age 59 ½, in addition to regular income taxes owed on the distribution amount, you may be subject to a 10% early withdrawal penalty if it doesn’t qualify for an exception. 

Plans can offer both in-service withdrawals and hardship withdrawals for active employees, but neither is required. A hardship distribution is when an individual withdraws money from their retirement account due to severe financial hardship or burden. Hardship distributions are subject to income tax plus additional tax. 

In-service withdrawals are available based on certain age and/or service requirements, as stated in the document. Many plans allow rollover contributions (funds you have rolled into the current plan from a prior provider) to be taken at any time, but deferrals and certain employer contributions are subject to restricted distribution options before age 59 ½.

You go through a divorce

A 401(k) typically arises during divorce proceedings. In many cases, couples going through a divorce split the 401(k), which requires preparing a qualified domestic relations order (QDRO) to assign benefits from a participant to an alternate payee.

You pass away

Having a beneficiary associated with your 401(k) can help ensure that the funds are directed where you want them to go in the event of your death. Otherwise, your beneficiary will be determined by your plan document, which generally orders your account to be paid to your spouse, children, or estate.