How does a 401(k) work?

How does a 401(k) work, step by step?

Strip away the jargon and a 401(k) is a fixed sequence of events that repeats every pay period, plus a couple of rules that only matter when you leave a job or reach retirement age.

1. You enroll in your employer's plan and pick a contribution rate, a percentage or flat dollar amount of each paycheck.
2. If your plan offers both, you choose traditional (pre-tax) contributions, Roth (after-tax) contributions, or a mix of the two.
3. That amount is deducted from your paycheck automatically, before you ever receive the rest of your pay.
4. If your employer offers a match, they add their own money on top, up to a formula they set (a common one: 50 cents per dollar you contribute, up to 6% of your pay).
5. Your contributions and any match are invested in whatever funds you selected from the plan's menu, usually a lineup of mutual funds and target-date funds.
6. The balance grows tax-deferred (traditional) or tax-free (Roth) as the underlying investments earn returns over the years.
7. Your own contributions are 100% yours immediately. Employer match money vests on a schedule, meaning you have to stay employed a certain number of years to fully own it.
8. Starting at age 59½, you can withdraw without the 10% early-withdrawal penalty (traditional withdrawals still owe ordinary income tax).
9. For traditional 401(k)s, required minimum distributions (RMDs) force you to start withdrawing at age 73, whether you need the money that year or not.

Source: IRS, 401(k) Resource Guide for Plan Participants; IRS, Retirement Topics: Vesting.

What is a 401(k)?

A 401(k) is a workplace retirement plan named for the section of the tax code that created it. Your employer sets it up and picks a plan provider; you sign up through that employer and direct part of your salary into it. The IRS describes it as a plan that lets employees make "elective deferrals" from their pay into an individual account inside the employer's plan. Unlike a savings account, the money is meant to stay invested for decades, and the tax code gives it special treatment in exchange for that: you either skip tax on the way in (traditional) or on the way out (Roth), never both.

How do 401(k) contributions come out of your paycheck?

You set a contribution rate, commonly a percentage of salary, when you enroll or at any point afterward through your plan's portal. Your employer's payroll system then deducts that percentage from every paycheck before you receive the rest. With a traditional 401(k), that deduction also lowers the wages your employer reports as taxable for federal income tax that pay period, so your take-home pay drops by less than the full contribution amount. With a Roth 401(k), the deduction comes out of pay that has already been taxed, so your paycheck drops by the full contribution and there is no upfront tax break. Either way, you never have to remember to "save" the money yourself. It leaves your paycheck automatically, which is the single biggest reason 401(k)s work better than most people's do-it-yourself saving plans.

What is an employer match, and why should you always get the full match?

A match is money your employer adds to your 401(k) based on how much you contribute, on top of your salary. A typical formula matches 50 cents or a dollar for every dollar you contribute, up to some percentage of your pay, for example 3% or 6%. If you contribute less than that threshold, you leave part of the match unclaimed, and it does not carry over or pay out later. It is simply gone.

Worked example. Say you earn $60,000 a year and your employer matches 50% of your contributions up to 6% of pay. If you contribute 6% ($3,600 for the year), your employer adds another 50% of that, $1,800. You put in $3,600 and $5,400 lands in your account, an instant 50% return on the money you contributed, before it has even been invested. Contribute only 3% instead, and you collect just $900 of the match instead of $1,800, quietly giving up $900 a year for no reason, a gap that compounds over decades of investment growth. This is the sense in which the match is often called "free money": no other part of investing hands you a guaranteed, immediate return simply for showing up.

What is vesting, and when do you own the match?

Vesting is when employer contributions actually become yours to keep, even if you leave the job. Your own contributions are always 100% vested the moment they hit your account. Employer match money is different: plans are allowed to make you wait. Under IRS rules, the two allowed schedules are cliff vesting (0% until three years of service, then 100%) and graded vesting (your ownership share rises each year until it reaches 100% at up to six years). Leave before you are fully vested and you forfeit the unvested match, though you always keep your own contributions and their growth.

What is the 2026 401(k) contribution limit?

For 2026, the IRS set the employee elective deferral limit at $24,500, up from $23,500 in 2025. This is the most you can contribute from your own pay in a calendar year; it does not include any employer match. Older workers get to contribute more through catch-up contributions.

Source: IRS, "401(k) limit increases to $24,500 for 2026"; IRS Notice 2025-67.

There is one more wrinkle from the SECURE 2.0 Act: for taxable years after December 31, 2026, if your wages from your employer the prior year exceeded a threshold (the figure used to test 2026 catch-up wages is $150,000), your catch-up contributions must go in as Roth rather than pre-tax. It affects only the catch-up portion of the contribution and only higher earners. For the full breakdown, including IRA limits and Roth income phase-outs, see our 2026 contribution limits page.

Traditional 401(k) vs Roth 401(k): what's the difference?

Both are 401(k)s with the same contribution limits and the same investment menu; the only difference is when you pay tax. A traditional 401(k) takes contributions pre-tax, lowering your taxable income now, and taxes every dollar (contributions and growth) as ordinary income when you withdraw it. A Roth 401(k) takes contributions after tax, with no deduction today, but qualified withdrawals in retirement are tax free, including all the growth. Unlike a Roth IRA, a Roth 401(k) has no income limit; anyone whose plan offers it can contribute, no matter how much they earn. If your tax rate in retirement will likely be lower than it is now, traditional tends to come out ahead; if it will likely be the same or higher, Roth tends to come out ahead. Many people split contributions between both to hedge the uncertainty. For a full side-by-side against a Roth IRA specifically, see Roth IRA vs 401(k).

How is the money in a 401(k) invested?

Your contributions and any employer match are not held as cash. They are invested in whatever funds you select from your plan's menu, which your employer and its plan provider choose in advance. Most menus consist of mutual funds and index funds covering stocks and bonds, plus target-date funds that automatically shift from stock-heavy to bond-heavy as you approach a target retirement year. If you never actively choose an investment, most plans default new contributions into a target-date fund matched to your expected retirement age. You do not pick individual stocks the way you might in a brokerage account; your choices are limited to whatever the plan's menu offers, which is one of the tradeoffs of an employer-run account versus an IRA you control yourself.

When can you withdraw from a 401(k)?

The rule that matters most: withdrawals before age 59½ generally trigger both ordinary income tax (on traditional dollars) and an additional 10% early-withdrawal penalty tax on top of it. There are exceptions, the best known being the "Rule of 55," which lets you take penalty-free withdrawals from the 401(k) of the employer you just left if you separate from service in or after the year you turn 55. After 59½, the 10% penalty goes away; traditional withdrawals are still taxed as ordinary income, and qualified Roth 401(k) withdrawals are tax free.

On the other end of the timeline, traditional 401(k) balances are subject to required minimum distributions (RMDs) starting at age 73: the IRS forces you to withdraw at least a minimum amount each year, whether or not you need it, and taxes it as ordinary income. Designated Roth 401(k) balances have not been subject to lifetime RMDs since 2024. For the full mechanics of how that minimum is calculated and what the penalty is for missing one, see what is an RMD?

The bottom line

A 401(k) is not complicated once you separate the moving parts: a set percentage leaves your paycheck automatically, an employer may add free money on top up to a formula (grab all of it, every time), the combined balance sits invested until retirement, and the tax code punishes early access (before 59½) while eventually forcing access on traditional dollars (RMDs at 73). Whether traditional or Roth contributions serve you better depends on your tax rate now versus in retirement, which nobody can know for certain, so splitting between the two is a reasonable hedge. The 2026 limits, $24,500 for most savers, $32,500 at 50+, $35,750 at 60 to 63, define how much of this tax-advantaged space is available to you this year.