How a 401(k) works: contributions, taxes and investments

A 401(k) is a retirement savings account offered through an employer. Money goes in straight from a paycheck, gets invested in funds the worker chooses from a menu, and is meant to stay there until retirement. The name comes from the section of the tax code that created it. For many households it becomes a significant part of their retirement savings, so it helps to understand the moving parts.

How money gets into the account

The main source is the employee's own pay. A worker chooses a percentage or dollar amount, and the employer sends that amount to the plan each pay period before the paycheck is deposited. The IRS calls these "elective deferrals."

Many employers add money as well. The most common form is a match, where the employer contributes a set amount for each dollar the employee puts in. Some employers also make contributions that do not depend on what the employee does. The post on how an employer match works covers the formulas.

Some plans enroll new employees automatically. Under automatic enrollment, the employer withholds a default percentage of pay unless the employee chooses a different amount or opts out. A person who was auto-enrolled may be contributing at a rate they never actively picked, which is worth checking.

There is an annual cap on how much an employee can defer. For 2026 the limit is $24,500, with additional catch-up amounts allowed for people age 50 and older, according to the IRS contribution limits page. The details are in the post on 401(k) contribution limits and catch-up contributions.

How the tax treatment works

A 401(k) can hold two kinds of employee contributions, and the difference is when income tax is paid.

• Traditional (pre-tax) contributions come out of pay before federal income tax is calculated. The IRS participant guide explains that these deferrals and their investment gains are not subject to federal income tax until they are distributed from the plan.
• Roth contributions, where a plan offers them, are made from pay that has already been taxed. Withdrawals that meet the rules for a qualified distribution are tax-free, including the earnings.

One point that surprises people: pre-tax deferrals still count as wages for Social Security and Medicare taxes. The income tax is postponed, but the payroll taxes are not.

Here is a hypothetical illustration. Suppose someone earns $60,000 and contributes 5% of pay, or $3,000, as traditional contributions. Their taxable wages for federal income tax purposes that year would be $57,000 rather than $60,000. If the same $3,000 went in as Roth contributions, taxable wages would stay at $60,000. The comparison between the two is covered in traditional vs. Roth 401(k) contributions.

Who chooses the investments

The employer, acting through the plan's fiduciaries, selects a menu of investment options. Each participant then decides how to divide their account among those options. The menu typically includes several mutual funds or similar pooled funds covering stocks, bonds and cash-like investments, and often a series of target-date funds.

A 401(k) is a "defined contribution" plan. As the SEC's investor education site explains, this kind of plan does not promise a specific benefit at retirement. The eventual balance depends on how much goes in, what the investments do, and what the plan and its funds cost. The investment risk sits with the participant, not the employer.

Participants who do not make a choice are usually placed in the plan's default investment. How to divide money among different kinds of investments is a personal decision that depends on time horizon and tolerance for risk; the SEC's overview of asset allocation and diversification is a useful starting point. Costs matter too, and the guide on what 401(k) fees cost explains how to find them.

What "vested" means for employer money

An employee's own contributions always belong to the employee. Employer contributions can be different. Many plans attach a vesting schedule, meaning the employee earns ownership of the employer's contributions over a period of service. Someone who leaves before being fully vested may forfeit part of the employer money. The post on vesting schedules explains the common patterns.

Getting money out

A 401(k) is built for retirement, and the rules discourage early use. Under the IRS's general distribution rules, plans generally allow distributions only after certain events, such as leaving the employer, reaching a specified age, disability or death. Some plans also offer loans or hardship withdrawals while a person is still employed.

Withdrawals of pre-tax money are taxed as ordinary income. In addition, the law generally imposes a 10% additional tax on distributions taken before age 59½, with a list of exceptions described in IRS Topic no. 558. One of those exceptions applies to distributions made after a person separates from service with the employer after reaching age 55.

At the other end, the law generally requires withdrawals from pre-tax accounts to begin at a certain age. Those required minimum distributions are a topic of their own.

The plan document is the rulebook

Federal law sets the outer boundaries, but each employer designs its own plan within them. Whether there is a match, how long vesting takes, whether loans are available, when new hires can join and which investments are offered all vary from plan to plan. The IRS notes one limit on waiting periods: a 401(k) plan cannot require more than one year of service as a condition of participating.

The document that lays all of this out is the Summary Plan Description, which the plan is required to give to eligible employees. Questions worth asking of any plan include:

• Is there an employer contribution, and what is the formula?
• What is the vesting schedule?
• Does the plan offer a Roth option?
• What are the investment options and what does each one cost?
• What happens to the account when employment ends?

On that last point, the guide to old 401(k) options describes the choices available after leaving a job.