401(k)

How it works

You authorize your employer to deduct a percentage of each paycheck and direct it into your 401(k) account before income tax is applied. The money goes into a menu of investment options chosen by your employer's plan administrator — typically a mix of target-date funds, broad index funds, and a few actively managed funds. Contribution limits are set annually by the IRS and adjusted for inflation; for 2025 the employee limit is $23,500, with a $7,500 catch-up contribution for workers age 50 and over.

The "tax-deferred" part is the core benefit. Contributions reduce your current-year taxable income, and investment gains compound without annual tax drag. You don't pay income tax on any of it until you start taking withdrawals in retirement, at which point distributions are taxed as ordinary income. Required Minimum Distributions begin at age 73.

Employer matching

Most plans include a matching contribution. A common formula is "100% match on the first 3% of salary, 50% match on the next 2%" — so contributing 5% of your paycheck triggers another 4% from the employer. That match is, almost without exception, the highest immediate return available in personal finance: a 100% match on 3% of salary is a guaranteed 3% raise contingent on saving. Not contributing enough to capture the full match is leaving money on the table.

Vesting schedules determine when the matched funds become legally yours. Typical schedules range from immediate vesting to graded vesting over three to six years.

Roth 401(k)

Many plans also offer a Roth version. Roth 401(k) contributions are made with after-tax dollars, and qualified withdrawals in retirement are entirely tax-free. The choice between traditional and Roth is essentially a bet on whether your tax rate will be higher in retirement (favor Roth) or lower (favor traditional). For most workers in their peak earning years, the traditional version is mathematically better; for early-career workers, the Roth often wins.

Common pitfalls

Cashing out on job change. When workers change jobs, their old 401(k) often gets cashed out as a small lump sum — incurring income tax plus a 10% early-withdrawal penalty if they're under 59½. The right move is almost always to roll it over into the new employer's plan or a Traditional IRA.

High-fee plans. Some employer plans, especially at smaller companies, have expensive fund options with expense ratios above 1%. Compounded over decades, this can cost six figures. If your plan is lousy, contribute up to the match and put additional savings into an IRA where you control the investments.

Borrowing from yourself. Most plans allow loans against the balance, often up to 50% or $50,000. This is generally a bad idea: the loan typically must be repaid quickly if you leave the job, and the borrowed funds aren't compounding while they're out of the market.