A 401(k) plan is an employer-sponsored retirement saving and investing plan in the Internal Revenue Code. Your employer may offer you this plan as a part of their benefits package. Once enrolled, 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 an effective defined contribution plan because it is employer-sponsored and tax-advantaged.

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 retire. 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 month, the contribution will be automatically taken out of your pay and invested along with your employer’s contribution.

The average rate of return on 401(k) retirement plans is 3% to 8%, which offers an easy way to grow your retirement funds.

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,” explains Teresa Dodson, founder of Greenbacks Consulting. The idea is to just let it grow,” Dodson says.

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 deducted from after-tax income. This means you don’t receive a tax deduction in the year you contribute. However, you don’t need to pay taxes on your investment earnings or qualified distributions in retirement.

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

401(k)Roth 401(k)Roth IRA
2023$22,500, $7,500 catch-up contribution$22,500, $7,500 catch-up contribution$6,500 if under 50, $7,500 if over 50
2024$23,000, $7,500 catch-up contribution$23,000, $7,500 catch-up contribution$7,000 if under 50, $8,000 if over 50

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.

The maximum amount you and your employer can contribute to your retirement plan is adjusted periodically. The annual limit for 2023 for 401(k) and Roth 401(k) plans is set to $22,500 per year for those under the age of 50. If you’re over 50 years of age, you can make an additional catch-up contribution of $7,500.

For 2024, the annual contribution limit is $23,000 for employees under the age of 50. For those who are 50 years or older, the catch-up contribution is an additional $7,500.

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 2023 for Roth IRA accounts is $6,500 if you’re under 50 and $7,500 if you’re over 50. 

In 2024, the annual contribution limit is $7,000 if you’re under 50 and $8,000 if you’re over 50. 

If you’re a single tax filer, your modified adjusted gross income must be less than $153,000 for 2023. For 2024, the threshold is $161,000. If you’re married and filing jointly, the income threshold is $228,000 for 2023 and $240,000 for 2024. 

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 enrollment in a new plan, ask if your employer offers matching contributions. We recommend contributing an amount that will allow 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 of prime rate plus 1%- 2% against your contributions. However, if you leave your job before you repay the loan, you’ll need to pay the 10% early withdrawal penalty. 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 lying to get a 401(k) hardship withdrawal can lead to fraud charges, tax implications, and financial penalties.

We recommend speaking 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?

Traditional 401(k) accounts are subject to the required minimum distributions (RMD) once you reach a certain age. This is the minimum amount you must withdraw penalty-free from the account. RMDs are considered taxable income.

Roth IRAs are not subjected to RMDs. Also, RMDs will no longer be required for Roth 401(k) plans from 2024.

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

Unless you’re over the age of 59½, avoid cashing out your 401(k) when you leave or change your job because 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. We also recommend that you 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.