What Is a 401(k) & How Does It Help You Plan for Retirement?

A 401(k) is one of the most popular retirement savings plans available, offering individuals a tax-advantaged way to save for their future. But how exactly does a 401(k) work, and how can it help you build a secure retirement? 

To help you decide if this is the right retirement option for you, we’re breaking down what a 401(k) is, the benefits, and how to make the most of it when planning for your retirement years.

What is a 401(k)?

A 401(k) is a type of tax-advantaged retirement savings plan for employees.

Once you start a 401(k) plan, you can make monthly contributions to your retirement savings. Often, employers will also match employee contributions up to a certain percentage, but they aren’t required to.

While 401(k) plans are relatively simple, there are some considerations to keep in mind. For one, you’ll need to abide by yearly contribution limits. There are also rules that dictate when you can withdraw your money, which we’ll cover in more detail below.

How does a 401(k) work?

If you’re signing up for a 401(k) for the first time, there are some key details you’ll want to understand.

Contribution limits

The IRS limits how much can be put into a 401(k) account each year. Employees can contribute up to $23,500 to a 401(k) plan in 2025, which is a $500 increase from the 2024 contribution limit. This limit applies to you regardless of your salary and filing status.

The combined employee and employer contributions limit for 2025 is $70,000, up from $69,000 in 2024.

If you’re age 50 to 59 or 64 or older, you’re eligible for an additional $7,500 in catch-up contributions

For 2025, the catch-up contribution limit remains $7,500, which you can save on top of the $70,000 standard limit for a total of $77,500.

Beginning in 2025, those between ages 60 and 63 will be eligible to contribute up to $11,250 as a catch-up contribution, if their plan allows.

401(k) withdrawal rules

Once you’ve built up your 401(k) savings, you may consider using your 401(k) to pay off debt or withdrawing money for big expenses. Before you take money out of your account, you’ll want to understand the 401(k) withdrawal rules.

If you want to make penalty-free withdrawals from your 401(k) plan, you need to be at least 59^½ years of age. If you withdraw money from a 401(k) account before you’re 59^½ years old, you’ll incur a 10% penalty on your withdrawal.

That said, there are a few exceptions, including:

• Total and permanent disability
• Unreimbursed medical expenses exceeding 7.5% of adjusted gross income
• Employee separation from service at age 55 or older

You may also qualify for hardship distributions for medical or funeral expenses, avoiding eviction or foreclosure, or repairing damage to your home.

Starting January 2024, a new IRS rule allows retirement plan owners to withdraw up to $1,000 for unspecified personal or family emergency expenses, penalty-free, if their plan allows. 

Generally, it is advisable to wait until you’re over age 59^½ to start withdrawing money from your 401(k).

What happens when you leave your job?

The good news is that you can often roll your existing 401(k) over to the retirement plan you opt into through your new employer.

Rolling over your 401(k) allows you to continue building on your existing retirement savings even after you’ve switched employers. You don’t usually have to pay taxes when you roll over a 401(k), and a rollover can help you avoid early distribution penalties.

With a direct rollover, your plan administrator can make a direct payment from your existing 401(k) to the account you’ve opened with your new employer. You don’t have to pay any taxes with this rollover method.

If you receive a direct distribution from a retirement plan, you have 60 days to deposit that money in a separate retirement plan. Taxes will be withheld from this distribution, which means the full amount you’ve saved won’t move to your new account.

In order for the full amount to transfer to the new 401(k), you will need to make up the tax withheld from personal funds. Any amount that you cannot add back in will become a taxable distribution to you. 

If you don’t move to a new employer, or your new employer doesn’t offer a 401(k) plan, your former employer may allow you to leave the plans in place to continue to grow until you are ready to retire. You may also consider rolling them over to a Traditional Rollover IRA. 

The same rules apply for this type of rollover as well. You can have it directly transferred to the new provider or you must make up any tax withheld for a full rollover. 

Types of 401(k) plans

In addition to a traditional 401(k), there are several different types of 401(k) plans, including:

• Roth 401(k): A Roth 401(k) is similar to a traditional 401(k), but the money you contribute isn’t taxed when you withdraw it. Some employers may offer both traditional and Roth 401(k) options.
• SIMPLE 401(k): SIMPLE 401(k) plans are for employers with fewer than 100 employees. Like a traditional 401(k), you don’t pay taxes on your SIMPLE 401(k) until you make withdrawals.
• Safe Harbor 401(k): A safe harbor 401(k) allows a company to be exempt from certain regulations, making it a popular choice for smaller businesses looking for a simple plan.
• Solo 401(k): If you own a business with no employees, you can start a 401(k) for self-employed individuals. Your spouse is also eligible for your one-participant 401(k) if they also work in the business.

Tax implications of contributing to a 401(k)

Contributing to any retirement plan has tax implications, but it depends on the type of 401(k) you choose.

Contributing to a tax-deferred 401(k) plan is one way to reduce your taxable income, which usually means a lower tax bill. The contributions you’re making directly reduce your take-home income, allowing you to defer some of your taxes.

While you can’t deduct 401(k) contributions as an employee (because you’ve already had your tax reduced prior to the contribution), employers can deduct contributions they make to employees’ 401(k) plans. This helps encourage employers to offer a contribution match for employees.

When you withdraw from 401(k) after age 59^½, the withdrawals you make will be taxed at your applicable income tax rate.

With a Roth 401(k), you’re contributing after-tax dollars to your account. That means your taxable income doesn’t change, and your taxes aren’t deferred until you retire. You don’t have to worry about taxes on Roth 401(k) withdrawals because the money is already taxed. This also means that the growth of these funds isn’t taxed.

401(k) vs. other retirement savings options

401(k) plans are a popular choice because they’re easy for the employee to contribute, but there are several retirement savings options worth considering when planning for your future.

If your employer doesn’t offer a 401(k) plan, you can set up an individual retirement account (IRA) instead. You can set up a traditional or Roth IRA through most financial institutions, and there are no age limits.

Roth and traditional IRAs have much lower contribution limits than 401(k) plans. While you can contribute up to $23,500 to your employer-sponsored 401(k), the annual IRA contribution limit is just $7,000 for 2025.

Fortunately, you can save more when you get closer to retiring. Both IRAs and 401(k) plans allow you to make catch-up contributions if you’re 50 or older.

Roth IRA vs. 401(k)

Tips for maximizing your 401(k)

The easiest way to maximize your 401(k) plan savings is to contribute as much as you can afford each month. The more you contribute, the faster the money in your account will grow.

It’s also worthwhile to talk to your employer about the contribution match they offer and try to contribute enough to receive the maximum allowable match. This is free money added to your account for your retirement! 

If you have questions about your 401(k) plan or how it’s being invested, you can reach out to your HR manager. A financial advisor may also be able to help you maximize your 401(k) savings.