What Is a 401(k)? Everything You Need to Know

If you just started a new job and you’re looking at your 401(k) options, you probably have questions about how it all works.

You might be wondering: How do I know these are good investment options? How much should I invest? And what in the world does “vesting” mean?

If you’re leaning on your 401(k) to be a big part of your plan for retirement, it’s important to get your questions answered. Your golden years literally depend on investment choices you make today. Learning how your 401(k) works is the first step toward making confident decisions about your retirement.

Let’s get started!

What Is a 401(k) Plan?

A 401(k) is an employer-sponsored plan for retirement savings. The 401(k) and other similar employer-sponsored retirement plans allow employees the benefit of having retirement savings taken out of their paychecks. If your workplace offers a 401(k), you’ll fill out an enrollment packet that includes information about vesting, beneficiaries and investment options.

There are two main types of 401(k)s—traditional and Roth. Both are employer-sponsored retirement savings plans, but they come with slightly different tax advantages.

How Does a 401(k) Work?

First, let’s walk through the basics. When you sign up to participate in your 401(k), you get to decide how much to invest and what to invest in based on what your 401(k) plan administrator offers (we’ll talk more about that later).

Then, that money will be deducted automatically from your paycheck to invest in the options you chose. If you’re already enrolled in your company’s 401(k) plan, check your pay stubs to find out exactly how much you and your employer (if they offer a company match) are contributing to your 401(k).

According to The National Study of Millionaires, 8 out of 10 millionaires invested in their company’s 401(k) plan, and that simple step was the key to building a seven-figure net worth.

Tax Advantages

Whether you’re looking for an edge on the basketball court or for that special ingredient that’ll elevate your chocolate chip cookie recipe above Mrs. Johnson’s down the street, it’s totally normal to want to find that one thing that’ll give you a leg up on the competition.

When it comes to saving for retirement, your 401(k) offers that special ingredient in the form of tax advantages that help your investment dollars go further.

Market chaos, inflation, your future—work with a pro to navigate this stuff.

You see, your 401(k) is like a warm, fuzzy sweater that shelters your investments from the harsh, bitter elements—which, in this case, are taxes. But how it protects your investments from taxes depends on whether you have a traditional 401(k) or a Roth 401(k).

Traditional 401(k): Pre-Tax Contributions and Tax-Deferred Growth

When you put money in a traditional 401(k), you get your tax benefits on the front end.  Translation? The money you invest in your 401(k) doesn’t get taxed right away. Instead, your contributions go in tax-free, and you’ll pay less in taxes when you file your tax return. That’s because every dollar you contribute lowers your taxable income for the year, and less taxable income means less taxes. That’s not a bad deal!

However, you will have to pay taxes on your contributions—along with your employer’s contributions and any investment growth you earn—when you take that money out in retirement.

You get the tax break now, but you’ll have to pay the tax man somewhere down the line.

Roth 401(k): After-Tax Contributions and Tax-Free Growth

If your company offers a Roth option, you can enjoy tax-free growth and tax-free withdrawals in retirement later. That’s because the money you invest in your Roth 401(k) is after-tax dollars, which means it gets taxed before it goes into the account.

You won’t get a tax break now like you would with a traditional 401(k), but you won’t pay a dime on that money when you take it out in retirement. Think of it as a form of delayed gratification—you’re passing up a nice tax break now in exchange for a greater tax break later.

(Side note: Your employer contributions to a Roth 401(k) still go in tax-deferred, so you will have to pay taxes on that money when you take it out.)    

Both types of tax advantages are great, but if your employer offers a Roth 401(k), we always recommend taking that option. Allowing your money to grow tax-free for decades and then not having to worry about taxes when you’re living out your retirement dreams? Sign us up!

Contribution Limits

Keep in mind that the IRS sets contribution limits for how much you can invest in your 401(k) each year. For 2025, you can contribute up to $23,500 to your 401(k).¹

If you’re age 50 or older, you can invest an additional $7,500 as a catch-up contribution. But there’s an exciting new addition this year. Thanks to the SECURE 2.0 Act, there’s now an enhanced catch-up contribution for those between ages 60–63. Folks in that age group can make a higher catch-up contribution of $11,250 in 2025.²

Employer Match

There are lots of reasons to love 401(k)s, but the employer match might be one of our favorites. It’s a benefit that many companies offer with their 401(k) plans to encourage their employees to save for retirement. Basically, if you put money in your retirement plan, they’ll pitch in too.  

If your employer offers a company match on your 401(k) contributions, that’s free money!

Employers structure their company match formula in different ways, but the fixed-percentage match is the most common. That’s where employers match a certain percentage of your income. For example, if your company offers a 100% match up to 4% of your $100,000 salary, you’ll get a dollar-for-dollar match on up to $4,000 of your contributions (and nothing more beyond that).

The good news is, the vast majority of companies (86%) with a 401(k) plan provide some kind of match on employee contributions. And the average employer match is around 4.6% of your salary.³ Even if your employer match is less than that, that extra money can make a big difference in your nest egg over time.

One last thing on employer matches: Find out if you need to stay with your company for a certain amount of time before the matching funds are fully yours. Your company might have a vesting schedule, meaning you have to stick around for a few years or more before you can walk away with all your matching contributions.

401(k) Withdrawal Rules

When life happens, it’s easy to turn to the savings stashed in your 401(k). The money’s just sitting there, right? Turns out, withdrawing money from your 401(k) early is more complicated than that.

According to the IRS, you generally can’t withdraw money out of your 401(k) before you reach the age of 59 1/2 without paying income taxes and a 10% early withdrawal penalty.⁴

But there is a loophole: 401(k) loans allow you to use your retirement savings without paying penalties or taxes as long as you pay the money back. Of course, doing this comes with a bunch of rules, and things can go really wrong, really fast.

Here’s why 401(k) loans are a terrible idea:

• You have to pay back the amount you withdraw with interest.
• Your investments into your workplace 401(k) account are pre-tax, but you’ll pay back the loan with after-tax dollars. That means it will take longer to build up the same amount.
• You’ll have to pay additional taxes and penalties if you don’t pay back the loan in a certain time frame.
• If you leave your job for whatever reason and still have an outstanding 401(k) loan balance, you have to pay it back in full by the tax filing deadline of the following year, including extensions (thanks to the Tax Cuts and Jobs Act of 2017).⁵ 
• When you borrow from your 401(k), that money loses its ability to grow until the loan is paid in full and the money is put back in the account. 

That’s a lot of good reasons to keep your hands off your 401(k) until you reach retirement age.

What Investment Options Do I Have With a 401(k)?

Now comes the fun part: choosing which investments to include in your 401(k). Most companies partner with an investment firm to administer their 401(k) plan and offer a select menu of investment options for you to choose from.

The one downside about 401(k)s is that they usually offer a limited number of options. You might get to pick and choose from just a handful of investments or up to a couple dozen investments. And larger companies might offer a more diverse group of offerings. It all depends on the company.

Here are some common investment options you might find in your 401(k) plan:

• Target date funds: These are mutual funds that gradually change your investments from aggressive (high risk, high reward) to conservative (low risk, low reward) options as you get closer to retirement.
• Stock mutual funds: Stock mutual funds let you invest in shares of many company stocks at once, from the largest and most stable to the newest and fastest growing.
• Bond funds: Bonds let companies or governments borrow money from you. In return, you earn a fixed rate of interest on your investment while the company or government repays the debt over time.  
• Single stocks: Some companies will let you invest in their own stock as a way to participate in the growth of the company you work for.
• Index funds: These are mutual funds that mirror the performance of the stock market or a particular area of the stock market.

So, which investments are best for your portfolio? If they’re available, we recommend spreading your 401(k) contributions evenly across four types of growth stock mutual funds: growth and income (large cap), growth (medium cap), aggressive growth (small cap) and international.

We recommend this mix of investments because it allows you to harness the power of investing in the stock market while diversifying your investments and lowering your risk in the process.

If you have questions about your 401(k) investment options, you should set up a meeting with your financial advisor or talk to your 401(k) plan administrator.

How Much Should I Invest in My 401(k)?

After you’ve picked your investment options, you get to decide how much you want to contribute to your 401(k) with each paycheck.

Generally, you can set up your contributions as a percentage of your salary or as a fixed dollar amount.

We recommend going with a percentage of your salary. That way, your retirement savings will automatically increase whenever you get a raise. That makes investing super easy.

Deciding what percentage of your salary to invest in your 401(k) depends on a couple different factors.

• First, we recommend saving 15% of your gross income for retirement (once you’re out of debt and have a fully funded emergency fund).
• Second, when deciding where and how to prioritize your retirement savings, remember this: Match beats Roth beats traditional. 

So, does your employer offer a match on your contributions? Great! Start there. You should invest enough to get the full employer match. That’s free money, and we don’t say no to free money!  

After you take advantage of the match, then what? Should you invest for retirement in your 401(k) and nothing else? Not necessarily. Here are a couple options:

• Option 1: You have a Roth 401(k) with great mutual fund choices. Good news! You can invest your whole 15% in your Roth 401(k) if you like your plan’s investment options.
• Option 2: You have a traditional 401(k). Invest up to the match, then contribute what’s left of your 15% to a Roth IRA. Your financial advisor can help you get one started. If you contribute the maximum to your Roth IRA and still have money left over, you can go back to your traditional 401(k).

No matter what, the most important factor in having a secure retirement is contributing consistently into your 401(k) over the long haul.

When Should I Start Investing in My 401(k)?

This is important, so listen up! Don’t start investing until you’re out of debt (everything except your mortgage) and have a fully funded emergency fund. If you’re currently investing but still haven’t paid off your debt or built up your emergency fund, it’s time to hit the pause button. Temporarily stop putting money into your 401(k) and focus on taking care of those two steps first.

Why? Because your income is your greatest wealth-building tool. And when your income is tied up in debt payments, you’re robbing yourself of a chance to build wealth. Debt equals risk—get it out of your life as fast as you can using the debt snowball.   

And if you start investing without an emergency fund in place, where do you think you’ll look for money when the air conditioner in your home dies in the middle of July? That’s right—your 401(k).

But if you take money out of your 401(k), you’re not just putting your retirement future at risk. You’re also going to get hit with taxes and early withdrawal penalties that will eat up most of your nest egg before you even see it. That’s why having an emergency fund with 3–6 months of expenses is so important.

Being debt-free with a fully funded emergency fund gives you a firm foundation that will protect your investments when life happens. And believe us, life will happen!

 

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.