What Is a 401(k)? Retirement Plan Basics

A 401(k) is an employer-sponsored retirement savings plan that allows you to save a specified amount of your income, which gets invested and can offer valuable tax benefits. Employers often add to your contribution. The term “401(k)” comes from Section 401(k) of the Revenue Act of 1978, which allows for tax-free deferral of income. It became law on January 1, 1980, establishing what we know today as the 401(k). 

Discover the basics of 401(k) plans, including how they work, the various types, and how they can benefit you. 

How does a 401k work?

What is a 401(k), and how does it work? A 401(k) is a retirement plan that helps employees save for retirement, invest that savings, earn dividends on their investments, and lower their tax burden. The steps involved with creating a 401(k) involve:

1. Signing up

2. Choosing how much you’ll contribute

3. Choosing your investment strategy

4. Saving over a period of time

Explore these steps in detail below.  

1. Signing up for a 401(k)

It starts with you participating in your employer’s 401(k) plan. You typically do this when you first join a company, but many employers will allow you to sign up anytime while employed. If you need help signing up for employer-sponsored retirement savings plans, speak with your human resources (HR) department.

Remember, some employers might automatically enroll you in their 401(k) accounts unless you request not to. They will also automatically set a low contribution rate—generally 2 percent of your salary [1]. 

2. Choosing a contribution amount

When you sign up, you choose a contribution amount. Many 401(k) plans let you choose whether you invest a fixed dollar amount per pay period or a certain percentage of your take-home (pre-tax) pay during each pay period. Because your employer takes this contribution from your pre-tax income, you will pay less in income tax. 

For example, if you earned $1,000 per week pre-tax and had $100 taken out for your 401(k), the IRS will base your income tax upon $900 instead of $1,000. 

Many employers entice workers to join 401(k) plans by offering employer matches on contributions. With this benefit, your employer matches a certain amount of your contributions to your 401(k). A typical employer match is 100 percent on up to 5 percent of your pre-tax income. So, if you earn $1,000 per week and contribute $50 to your 401(k), your employer will also contribute $50 to your 401(k), bringing the total contribution to $100. Now, if you contribute $100, your employer will still only contribute $50 because they will only match up to 5 percent of your income that pay period. 

3. Choosing your investments

Many 401(k) providers will allow you to choose from a range of investment options, often in the form of company stock, individual stocks, bonds, other securities, or variable annuities. When selecting these investments, speaking with a financial advisor is wise to determine what investments are best for your retirement plans. 

As with any investment, the value will rise and fall, and you may earn dividends when a company distributes a portion of its earnings to shareholders. This growth and the dividends you receive are how a 401(k) becomes large enough to fund your retirement. 

4. Continue funding your 401(k)

Now that you’re all set up, your employer will take the amount of cash you earmarked for your 401(k) from your paycheck and invest it as requested. You may be able to log into your 401(k) provider’s website and adjust your investments. 

You continue funding this 401(k) account until you leave that employer or retire and begin taking disbursements from the 401(k) account. We’ll cover both scenarios later. 

Who can participate in a 401(k) plan?

Two rules apply when deciding who can participate in a 401(k) plan. First are the minimum rules the Internal Revenue Service (IRS) sets. According to the IRS, an employer must permit an employee to participate in its sponsored 401(k) plan if the employee is at least 21 years old and has at least one year of service with the company. The employer can withhold the employer match portion of the 401(k) until the employee has reached two years of service. 

The IRS rules set the baseline, but the employer is primarily free to set its own rules, so long as they are within the IRS’ regulations. For example, an employer could say employees are eligible to participate in its 401(k) after 90 days with the company and eligible for the employer match after one year of contributing. 

Also, remember that the IRS does not permit you to put all your income in a 401(k). It sets contribution limits every year. For example, the 2024 contribution limit is $23,000, an increase from $22,500 in 2023. The IRS also allows what some commonly call “catch-up contributions” for people ages 50 and older. In 2023, this is an additional $7,500, a $1,000 increase from 2022 [2].

401(k) vs. IRA: What’s the difference?

A 401(k) is one of many available retirement account options. One other popular option is the individual retirement account (IRA). An IRA is another retirement account option owned and operated by you as an individual rather than your employer. Though you own the plan, some employers will help you establish and fund an IRA. 

Tax benefits

IRAs and 401(k) retirement accounts have tax benefits, but the benefits differ significantly. With a 401(k), your contributions are almost always tax-deductible, reducing your taxable income each pay. The taxes of an IRA vary by type. 

In a traditional IRA, the money you put into the account may be partially or wholly tax-deductible. In addition, all your earnings from your IRA are only taxable once you take a distribution from the IRA. Once you start taking disbursements from your IRA, the IRS considers the disbursement amount income and taxes each disbursement as such. For example, if you opt for $2,000 weekly payouts, you will be subject to state and federal income taxes on that full $2,000 each week. 

In a Roth IRA, you don’t receive any tax deductions for the money you put into the account. The IRS doesn’t tax any disbursements you take—any earnings included—as income. 

Participation rules

While the IRS only sets guidelines for employers’ 401(k) accounts, it is much more controlling of who can participate in an IRA. The IRS bases these limitations on your income. 

Overall, the IRS permits you to contribute $7,000 annually to a Roth or traditional IRA—$8,000 for those over age 50. However, your Roth IRA contribution limit decreases with your income [2]. 

The IRS’ Roth IRA contribution scale changes annually, but in 2023-24, it eliminates all Roth IRA participation if you earn $153,000 or more and file as single, head of household, or married filing separately and not living with your spouse during the tax year [3]. You also cannot participate in 2023-24 if you’re: 

• Married filing separately and lived with your spouse at any point during the year and earned $10,000 or more 

• Married filing jointly or a qualifying widow(er) and earned $228,000 or more 

In addition to these disqualifiers, the IRS reduces the amount you can contribute to a Roth IRA as you approach the disqualifying amount. This contribution limit is calculated on the IRS’ IRA contribution scale.

The IRS sets no income and participation limitations on 401(k) retirement accounts. 

Loans

With a 401(k), you can sometimes take penalty-free loans of up to $50,000 or 50 percent of your balance (whichever is less) if you need extra cash [4]. This loan will include interest, but the interest you pay goes back into your 401(k), so you’re paying yourself interest. 

As for an IRA, the IRS does not permit you to take loans out against the balance. The only option is to withdraw funds and pay any applicable income taxes and a 10 percent penalty [5]. 

401(k) benefits and disadvantages

A 401(k) is among the most popular employer-sponsored retirement accounts because these plans offer some key benefits. Let’s review the advantages and disadvantages of a 401(k) account. 

401(k) benefits

Some of the key benefits of a 401(k) account are as follows: 

• Your employer automatically withdraws contributions from your paycheck.

• Your contributions lower your tax burden, reducing income taxes.

• You pay no taxes on 401(k) growth until you withdraw money.

• The withdrawal rules can reduce the urge to withdraw and spend your savings.

• You can often choose your investment strategy and adjust it as needed.

• You can take out penalty-free loans against your 401(k) balance if needed.

• Employer matches are like getting free money.

• You can roll them into a 401(k) at a new employer without penalty.

401(k) disadvantages

While the benefits of a 401(k) are great, they have disadvantages too, such as: 

• You will pay a 10 percent penalty plus income taxes if you need to withdraw money before you turn 59.5 years old. 

• 401(k) accounts are generally not FDIC insured, and you can lose 100 percent of your investment.

• You must often endure a waiting period before money from an employer match becomes yours—these are also called vesting periods.

• An economic downturn can significantly reduce your 401(k) value.

Types of 401k plans

You have many 401(k) options to pick from. The IRS offers several options, but the IRS designed each for specific scenarios.

Traditional

You will typically encounter a traditional 401(k) retirement account at an employer. These allow you to set pre-tax contributions to your 401(k) account up to the IRS contribution limit for that year. They also often include an employer match, though you may need to go through a vesting period before the matching cash is yours. 

Roth

A Roth 401(k) is similar to a Roth IRA. The money you contribute to the account doesn’t qualify for tax deductions because you pay using after-tax income. This means the plans are not subject to income tax if you withdraw after you turn 59.5 years old. 

Solo

A solo 401(k) plan is for self-employed folks or small businesses with only one employee. It allows sole proprietors and contractors to take advantage of a 401(k) account, which is especially handy if they exceed the income limits for an IRA. 

Solo 401(k) accounts are available as traditional or Roth structures. However, they often have higher contribution limits. For example, the 2024 IRS contribution limit for a solo 401(k) is up to $69,000, but additional limitations based on your self-employment income and contribution types exist [6]. 

SIMPLE

The IRS designed the Savings Incentive Match Plan for Employees (SIMPLE) 401(k) primarily for startups without a retirement plan. Its main limitation is that the company can have no more than 100 employees. Other factors setting a SIMPLE 401(k) apart are that the employer is required to match the employee's contribution, paying as much as 3 percent of the employee's pay or a non-elective contribution of up to 2 percent of the employee’s salary. 

A SIMPLE 401(k) also has a lower contribution limit. For example, in 2024, the IRS contribution limit is $16,000, plus $3,500 in catch-up contributions [7].  

Multiple Employer Plan

A Multiple Employer Plan (MEP) 401(k) is a retirement plan that two or more unrelated employers adopt. An MEP sponsor organizes and runs the MEP, making them responsible for administrative tasks and liabilities. This arrangement is ideal for small businesses without the bandwidth to handle this. 

How and when can you access your 401(k) benefits at retirement?

Current rules require you to reach the age of 59.5 to access your benefits without penalties. Once you retire, you have several options to access the nest egg you’ve built. You have several options to access those benefits, including the following: 

• Lump-sum distribution: You can withdraw 100 percent of your 401(k) balance (less applicable fees and taxes) and deposit and invest this cash where you see fit. 

• Periodic distributions: You can set up regular distributions from your 401(k) that are sent to you in a check or automatically deposited into your bank account weekly, monthly, or quarterly. This allows the remaining balance in your 401(k) to grow, potentially stretching your retirement funds further. 

• Purchase an annuity: You can also take all or some of your 401(k) balance and purchase an annuity. It helps guarantee a certain amount of income for the rest of your life, but it’s not inflation-adjustable and could leave you short on income in later years. 

• IRA rollover: You can also roll your 401(k) into an IRA if you’re dissatisfied with the investment options your 401(k) has. It is also a good option for people with multiple 401(k) accounts who want to consolidate.

Learn more about personal finances

So, what is a 401(k)? A 401(k) is an integral part of any retirement strategy. Thanks to its tax advantages, the ability to grow in value over the years, and the typical employer match, it has the potential to be a significant part of your retirement nest egg. But saving for retirement all starts with a strong foundation in the ins and outs of personal finance. 

Gain a better grasp on your personal finances and empower you with the knowledge you need to succeed. Consider helpful courses on Coursera, such as SoFi’s Introduction to Personal Finances or Saving Money for the Future, to help you start saving.  

Frequently asked questions (FAQ)

You likely have some lingering questions now that you know what a 401(k) is. We have the answers to some of the questions people often ask about 401(k) accounts.