401(k) retirement plans explained: What they are and how they work

Named after Section 401(k) of the Internal Revenue Code, a 401(k) plan is a type of retirement plan. It is offered by employers and allows eligible employees to contribute part of their income on a pre-tax or after-tax basis. This type of retirement plan helps workers grow their savings through investment options such as mutual funds, target-date funds, or exchange-traded funds (ETFs).

Most 401(k) plans are tax-advantaged. This means your contributions reduce your taxable income in the year they’re made. Some types of 401(k) plans give you the option of paying taxes up front and then receive your distributions in retirement tax-free. The IRS (Internal Revenue Service) oversees all 401(k) plans. To ensure compliance and to protect the rights of the taxpayers, all 401(k) plans follow the rules set by the IRS. Many 401(k) plans automatically enroll new employees and may include an employer match, meaning your employer contributes extra money to your account based on how much you save.

A 401(k) retirement plan can be a helpful tool to help you prepare for your financial future, whether you’re just starting out or getting closer to retirement. Two of the most common types are the traditional 401(k) and the Roth 401(k), each offering different tax advantages depending on your situation.

A traditional 401(k) allows employees to make pre-tax contributions from their paycheck, which lowers their taxable income in the year of contribution. The money grows tax-deferred, and distributions are taxed as ordinary income when withdrawn in retirement. Most plans include employer matching, and annual contribution limits are set by the IRS. This option is ideal for individuals who expect to be in a lower tax bracket after they retire.

A Roth 401(k) is an employer-sponsored retirement plan that allows you to make after-tax contributions to the 401(k), meaning you pay income tax on your contributions now, rather than later. In return, your investments grow tax-free, and qualified withdrawals in retirement aren’t taxed at all.

Like a traditional 401(k), a Roth 401(k) often includes an employer match and follows the same IRS contribution limits. The key difference is in how the account is taxed, making the Roth option attractive to employees who expect to be in a higher tax bracket in retirement or who want tax-free income later in life.

A 401(k) plan lets you set aside a portion of your paycheck into a retirement account, often through automatic payroll deductions. These contributions can be invested in a range of options, such as index funds, ETFs, or target-date funds, depending on what your employer’s plan offers.

Over time, your investments have the potential to grow through compounding, meaning your earnings can generate their own earnings. This tax-advantaged structure — whether pre-tax in a traditional 401(k) or after-tax in a Roth 401(k) — helps build long-term retirement savings. Many employers also offer a 401(k) match, contributing additional funds based on how much you save.

Each year, the IRS sets a maximum amount you can contribute to your 401(k) plan. For 2025, the contribution limit is $23,500 for employees under 50.¹ These limits help ensure fair use of the tax advantages and are adjusted regularly for inflation. In addition to the standard contribution limit, individuals aged 50 and older can make catch-up contributions to help boost their retirement savings as they approach retirement age. Over the age of 50, you are allowed to contribute an extra of $7,500 and an extra $11,250 if you’re aged 60-63.

Both traditional and Roth 401(k) accounts follow the same annual limits, and employer matching contributions do not count toward your personal cap. While these limits can change from year to year, they’re an important part of planning your long-term savings strategy.

There are specific rules set by the federal government about when you can withdraw money from your 401(k) plan. If you want to avoid paying a penalty, you need to wait until the age of 59½ to access your money. Usually, if you withdraw money from your 401(k) earlier than that, you will need to pay a 10% penalty plus income tax. However, there are a few exceptions, such as reaching age 55 and at the same time separating from your employer, foreclosure, or financial hardship from medical costs.²

Some plans allow you to take a loan from your 401(k).² This way, you can avoid paying the penalty and income tax. However, in this case, the repayments will also be deducted from your paycheck, meaning your net salary will also go down. For this approach, there are a few disadvantages to consider. If you take a loan from your 401(k), you miss out on the opportunity to grow your money and if your employment situation changes, you might have to repay the loan in a short amount of time. If you’re not able to pay back the money, it is considered a withdrawal again and you may need to pay both taxes and the 10% penalty if you're not 59½.

Required minimum distributions (RMDs) are the withdrawals you’re legally required to take from your 401(k) once you reach age 73, according to the IRS. Your first RMD must be taken by April 1 of the year after you turn 73, and each one after that by December 31 annually. The withdrawal amount is based on your account balance and an IRS life expectancy factor. If you miss an RMD, a 25% tax penalty applies, but that can drop to 10% if corrected promptly.³

As of 2024, Roth 401(k) accounts are no longer subject to RMDs during the account owner’s lifetime, making them a more flexible option for long-term retirement planning.³

Getting started with a 401(k) is often simple if your employer offers a plan. Here’s what to expect when setting one up:

• Check if your employer offers a 401(k): Most plans are set up through employers. Ask your HR department if a 401(k) retirement plan is available and whether you’re eligible.
• Enroll in the plan: Some employers use automatic enrollment, while others require you to sign up manually. You’ll usually fill out a form or enroll through an online portal.
• Choose your contribution amount: Decide how much of your paycheck you want to contribute. You can start small and increase over time. Keep in mind that your contributions are either pre-tax (traditional) or after-tax (Roth).
• Pick your investment options: Most plans offer a selection of mutual funds, ETFs, or target-date funds. Your choices affect how your savings grow over time.
• Take advantage of employer matching: If your employer offers a 401(k) match, try to contribute at least enough to get the full benefit — it’s essentially free money for your retirement.Monitor and adjust as needed: Review your account regularly and update your contributions or investment mix as your income and goals evolve.

When you leave a job, you generally have four options: leave your 401(k) with your former employer, roll it over to your new employer’s plan, transfer it to an IRA, or withdraw the funds. Be aware that early withdrawals may be subject to taxes and penalties.

A 401(k) plan offers a structured way to save for retirement, often with added benefits from your employer. However, like any financial product, it comes with both advantages and limitations you should consider.

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

Sources

¹https://www.irs.gov/newsroom/401k-limit-increases-to-23500-for-2025-ira-limit-remains-7000

²https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules

³https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs