A Helpful Guide to 401(k) Plans

Turbo Takeaways

A 401(k) plan is an employer-sponsored retirement saving and investing plan that provides tax advantages. Your employer may offer you this plan as a part of their benefits package.

Once enrolled in a 401(k) plan, you can contribute a portion of each paycheck, and your employer may match a percentage of your contributions.

There are two types of 401(k) retirement plans: traditional and Roth. The main difference between the two is how they’re taxed. If you want to save for retirement, a 401(k) is a defined contribution plan because it is employer-sponsored and tax-advantaged.

Planning for retirement starts with smart financial choices today. A 401(k) plan offers tax advantages, employer contributions, and a structured way to grow your savings over time. Keep reading to learn more about how the 401(k) plan works, the benefits it offers, and how you can maximize your retirement savings.

What Is a 401(k)?

A 401(k) is a retirement savings plan where you can have your contribution automatically taken out of your paycheck. Your employer may match a part of your contributions, and the money is invested in exchange-traded funds or mutual funds of your choosing.

The investment options available can vary significantly, but your investments will enjoy growth while shielding you from capital gains taxes and income taxes until you withdraw funds in retirement. You can choose from two types of retirement plans: traditional 401(k) and Roth 401(k).

How Do 401(k)s Work

One of the key advantages of a 401(k) plan is that it offers a simple and automated way to save for retirement. Each pay period, your contribution will be automatically taken out of your paycheck and invested along with your employer’s contribution.

The average rate of return on 401(k) investments varies based on asset allocation, market conditions, and fees but typically ranges between 3% and 8% over the long term.

Traditional 401(k)

In traditional 401(k) plans, your contributions are deducted from your gross income. This means any contributions you make to the plan reduce your taxable income and can be reported as deductions on your tax return.

“The key when you have a 401(k) plan is to have automatic withdrawal based on net income and never touch it. The idea is to just let it grow” explains Teresa Dodson, debt expert and founder of Greenbacks Consulting.

You won’t pay taxes on the money you contribute to your account or on your earnings from investments until you withdraw in retirement.

Roth 401(k)

Roth 401(k) contributions are made with after-tax income, meaning you don’t get a tax deduction for your contributions. However, the benefit is that your withdrawals in retirement are tax-free.

Not all employers offer Roth 401(k) plans. If your employer offers you this option, you can choose the plan you wish to enroll in or contribute to both as long as your contributions are within the annual limit.

401(k) and Roth 401(k) Contributions

Note: Starting in 2025, individuals aged 60 to 63 are eligible for a higher catch-up contribution limit of $11,250, as per the SECURE 2.0 Act.

The dollar limits for employer and employee plan contributions to traditional and Roth 401(k) accounts are set by the Internal Revenue Service (IRS). With a 401(k) plan, employee contribution is made with pre-tax money. With a Roth 401(k) plan, employee contribution is made with after-tax income.

Keep in mind that if you have both types of plans, you can split your contributions between the two. While maxing out 401(k) is ideal, your total contributions for the two accounts can’t exceed the annual limit listed above.

Roth IRA Contribution Limits

The annual contribution limits for Roth IRA accounts in 2025 are $7,000 if you’re under 50 and $8,000 if you’re over 50.

For 2025, if you’re a single filer or head of household tax filer, your Modified Adjusted Gross Income (MAGI) must be between $150,000 and $165,000 to make a partial Roth IRA contribution. If you’re married and filing jointly, the MAGI phase-out range is between $236,000 and $246,000.

Employer Matching

Some employers may match employees’ contributions based on a percentage of their salary. One common approach is matching $0.50 for every dollar of employee contribution, up to a total of 5% of their salary.

For example, if you receive $3,000 every pay period and contribute 5%, you’ll be contributing $150 with each paycheck, and your employer will contribute $75.

Before enrolling in a new plan, check whether your employer offers matching contributions and the specific terms. Contribute an amount that allows you to obtain the full employer match to get the full benefit.

Can You Withdraw From a 401(k)?

The money you save in your 401(k) account is intended to provide you with retirement income. However, for many Americans without sufficient funds in their savings account, the only option to cover sudden expenses such as overdue mortgage payments and medical bills is to withdraw from their retirement account.

If you’re in urgent need of cash and wondering if you can cancel your 401(k) and cash out while still employed, it's important to know that with a few exceptions, this can lead to a 10% early distribution penalty and income tax withholding due to IRS rules.

Some employers may allow you to take out a 401(k) loan at a low-interest rate, typically prime rate plus 1%- 2% against your contributions. If you leave your job before repaying the loan, the outstanding balance may be treated as a distribution and subject to income taxes and a 10% early withdrawal penalty if you’re under 59½. Check your plan rules to learn more about 401(k) loans.

Another option is to check your eligibility for a 401(k) hardship withdrawal for heavy financial needs, such as medical expenses, educational expenses, or funeral expenses.

Keep in mind that misrepresenting your financial situation to qualify for a 401(k) hardship withdrawal can lead to fraud charges, tax penalties, and possible disqualification of the withdrawal.

Speak to a financial advisor to check if taking out a loan or cashing your 401(k) as a last resort is advisable if you’re facing financial hardship.

What Are Required Minimum Distributions?

If you have a traditional 401(k), you must take your first required minimum distribution (RMD) the year you turn 73. However, you can delay this first withdrawal until April 1 of the following year. For example, if you turn 73 in 2024, your first RMD is due by April 1, 2025, and your second by December 31, 2025.

Previously, Roth 401(k) accounts were subject to Required Minimum Distributions (RMDs). However, beginning in 2024, thanks to the SECURE 2.0 Act, Roth 401(k) account holders are no longer required to take RMDs during their lifetime. That said, beneficiaries of Roth IRAs and designated Roth accounts are still required to follow RMD rules after inheriting the account.

What Happens to Your 401(k) When You Leave Your Job?

Unless you’re over 59½, avoid cashing out your 401(k) when you leave or change jobs, as you’ll have to pay the early withdrawal tax penalty. Here are a few things you can do instead:

• If your plan administrator allows, leave your 401(k) as is. However, you may have to keep track of multiple accounts.
• You may be able to roll your old plan’s balance to the plan offered by your new employer.
• You can also rollover your 401(k) plans into an individual retirement account. Make sure not to withdraw the amount but to use a trustee-to-trustee transfer to avoid penalties.

The Bottom Line on 401(k) Plans

With a 401(k) plan, you can save for retirement through automatic contributions and investing. Traditional 401(k) plans also reduce your taxable income, while Roth 401(k) plans will provide tax-free withdrawals when you retire.

Regardless of the option you choose, contribute consistently to the account. Take full advantage of employee matching, if available, by contributing enough to receive the full match so you don’t leave any free money on the table.