What it means
The plan takes its name from a section of the US tax code, which is why the name looks like a filing reference rather than a product. The employee chooses a deferral percentage of salary, the employer deducts it from each pay run, and the money is invested in a menu of funds selected by the plan sponsor.
The tax treatment is the main attraction. A traditional contribution reduces taxable income in the year it is made, so a saver in a 22% tax band gives up only about 78 cents of take-home pay for every dollar saved, and the account then grows without annual tax on dividends or gains.
The employer match is the part most worth paying attention to. A typical formula is 50% of the first 6% of salary deferred, which means an employee who saves 6% receives an extra 3% of salary they would otherwise never see, an immediate 50% return before any investment growth.
Matched money is often subject to vesting, meaning the employee must stay a certain number of years before the employer contributions become fully theirs. Employee contributions are always immediately owned by the employee, but leaving early can forfeit part of the match, which is worth checking before resigning.
There are limits and constraints in exchange for the tax break. Annual contributions are capped, withdrawals before the qualifying retirement age generally attract a penalty plus income tax, and required minimum distributions eventually force money out of the account, so the arrangement defers tax rather than avoiding it.
In practice
Real-world examples.
Example
A graduate joining a consultancy sets her deferral at 6% purely to capture the full employer match, on the reasoning that turning it down would be equivalent to declining a 3% pay rise.
Example
An employee changing jobs after 18 months discovers the plan has a three-year vesting schedule and forfeits $4,000 of employer contributions, money that would have been fully his had he stayed another 18 months.
Example
A 55-year-old who started saving late uses the catch-up contribution allowance available to older savers to put in more than the standard annual cap, accelerating the balance in the last decade before retirement.
Think of it
“401(k) plan is the employer retirement savings program-your workplace retirement account.
Formula
Calculation
Annual employee contribution = Salary x Deferral rate
Annual employer match = Salary x Match rate, subject to the plan's cap
Future value of level annual contributions = Annual contribution x (((1 + r)^n - 1) / r), where r is the annual return and n is the number of years
An employee earns $90,000 and defers 6% of salary. The employer matches 50% of the first 6% deferred, which works out at 3% of salary.
Employee contribution = $90,000 x 0.06 = $5,400 a year. Employer match = $90,000 x 0.03 = $2,700 a year. Total going into the account = $5,400 + $2,700 = $8,100 a year.
Because the employee contribution is made before income tax, someone in a 22% band reduces their tax bill by $5,400 x 0.22 = $1,188, so take-home pay falls by only $5,400 - $1,188 = $4,212 while $8,100 lands in the account.
Now project 20 years at a 7% average annual return. The annuity factor is ((1.07^20) - 1) / 0.07 = (3.8697 - 1) / 0.07 = 40.9955.
Future value = $8,100 x 40.9955 = approximately $332,000. Of that, $8,100 x 20 = $162,000 was contributed and roughly $170,000 is investment growth, which is the compounding effect that makes starting early so much more powerful than saving harder later.Case study
Seen in the real world.
Rowan Delacroix is an illustrative, fictional marketing manager earning $90,000 who had opted out of his employer's plan at 24 because the payslip deduction felt painful on a graduate salary. He rejoined the plan at 30 after a colleague pointed out he had been declining free money for six years.
Setting his deferral at 6% brought in the full 3% employer match, so $8,100 a year began flowing into the account while his take-home fell by only $4,212 thanks to the tax relief. Over the following 20 years at an average 7% return, the projection came to roughly $332,000 from $162,000 of total contributions.
The uncomfortable part of this fictional example was the six years he skipped. Contributions made in a saver's twenties have the longest to compound, and no amount of extra saving in his fifties would fully replace them, which is why plan administrators push automatic enrolment so hard.
Watch out
Common mistakes.
- Contributing less than the level needed to earn the full employer match. Money left on the table here is straightforwardly forgone pay, and no investment decision inside the plan matters more.
- Cashing out the balance when changing jobs. Doing so triggers income tax and usually an early withdrawal penalty, when transferring the balance to the new employer's plan or an individual retirement account keeps the tax shelter intact.
- Leaving contributions in the default cash-like option for years. The tax treatment does nothing on its own; the growth comes from being invested, and a decade in a near-zero return fund wastes most of the benefit.
Questions
People also ask.
What happens to the account if I leave the company?
The balance remains yours and can generally be left in the plan, moved to a new employer's plan or rolled into an individual retirement account, though unvested employer contributions may be forfeited.
Can I access the money before retirement?
Generally only with income tax plus a penalty on the amount withdrawn, although some plans allow loans or hardship withdrawals under specific conditions.
What is the difference between a traditional and a Roth 401(k)?
A traditional contribution reduces taxable income now and is taxed on withdrawal, while a Roth contribution is made from taxed income and qualifying withdrawals in retirement are tax free.
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