What it means
The plan works through payroll. You choose a percentage of salary to contribute, and it is deducted automatically before you see it.
With a traditional 401(k) the contribution comes out before income tax, lowering this year's taxable income; withdrawals in retirement are then taxed as ordinary income. With a Roth 401(k), which many employers now offer alongside, contributions are made from after-tax pay, but qualified withdrawals in retirement are entirely tax-free.
Either way, investment growth inside the plan is not taxed year by year, which allows compounding to work at full strength for decades. The employer match is the feature that makes a 401(k) hard to beat.
A common arrangement is a match of 50% of contributions up to 6% of salary, meaning an employee who contributes 6% receives an extra 3% from the employer. That is an immediate 50% return on the matched amount before any investment growth.
Matched money usually vests over a period of years, so leaving the employer early can forfeit part of it. The money is invested in a menu of funds chosen by the employer, typically including index funds, bond funds and target-date funds that automatically shift from equities to bonds as retirement approaches.
The IRS sets annual contribution limits, with a higher limit for people aged 50 and over, and the limits are adjusted most years. Withdrawals before age 59 and a half generally incur income tax plus a 10% penalty, with some exceptions, and required minimum distributions must begin in the early 70s.
When you change jobs the balance can be left where it is, rolled into the new employer's plan or moved to an individual retirement account.
In practice
Real-world examples.
Example
A 25-year-old graduate enrols at 4% of a $55,000 salary with a full 4% match, and by simply never opting out builds a six-figure balance by her late thirties.
Example
A 45-year-old catching up after years of low saving uses the higher over-50 contribution limit from age 50 to add several thousand dollars a year on top of the standard limit.
Example
An employee leaving a company after two years discovers that only 40% of the employer's matching contributions have vested and the rest is forfeited.
Think of it
“401(k) is a retirement account through your employer-tax-advantaged savings.
Formula
Calculation
Annual contribution = Salary x Employee contribution rate + Employer match
Future value = Annual contribution x [ ((1 + r) to the power n minus 1) / r ], where r is the annual return and n the number of years
Worked example. An employee earning $70,000 contributes 6% of salary and receives a 50% match on the first 6%.
- Employee contribution: $70,000 x 6% = $4,200 a year
- Employer match: $4,200 x 50% = $2,100 a year
- Total going into the plan: $6,300 a year
Tax effect of a traditional contribution at a 22% marginal rate: $4,200 x 22% = $924 less income tax this year, so the $4,200 of savings reduces take-home pay by only $3,276.
Growth over 30 years at 7% a year, with contributions held constant for simplicity:
- Future value = $6,300 x [ (1.07 to the power 30 minus 1) / 0.07 ] = $6,300 x 94.46 = $595,100
Of that, the employee's own contributions total $126,000, the employer's $63,000, and investment growth about $406,000. Raising the contribution to 10% (with the same 3% match) would lift the total to about $859,000.Case study
Seen in the real world.
A 150-person software company had a 401(k) with a generous 100% match on the first 4% of salary, yet only 55% of staff participated and most of those contributed exactly 4%. The HR director estimated that employees were collectively leaving about $180,000 a year of free match on the table. The company switched to automatic enrolment at 4%, with an automatic 1% increase each year up to 10% unless the employee opted out, and added a target-date fund as the default investment.
Within a year participation rose to 91% and the average contribution rate climbed to 6.5%. The company's own matching cost rose by about $140,000, which it had budgeted for, and staff surveys showed retirement benefits jumping from the eighth to the second most valued benefit. Employees had not changed their minds about saving; the plan had simply stopped asking them to fill in a form.
Watch out
Common mistakes.
- Contributing less than the amount needed to capture the full employer match. That is turning down part of your pay.
- Leaving the balance in cash or a money market fund by default for years. Long-term money should be invested for growth.
- Cashing out a 401(k) when changing jobs. Tax and the 10% penalty can consume a third or more of the balance; roll it over instead.
Questions
People also ask.
Traditional or Roth 401(k)?
If you expect a higher tax rate in retirement than today, Roth is usually better; if lower, traditional. Many people split between the two to hedge.
What happens to my 401(k) if I leave the company?
Your own contributions and vested match are yours. You can leave the plan in place, roll it to a new employer's plan or to an IRA.
Can I borrow from my 401(k)?
Many plans allow loans up to certain limits, repaid through payroll with interest. It can be useful in an emergency but stops the borrowed money from growing and can become taxable if you leave the job before repaying.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%