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What is a 401(k)?

A 401(k) is an employer-sponsored retirement savings plan named after a section of US tax law. It allows employees to set aside pre-tax income for retirement, grow it tax-free, and receive matching contributions from their employer.

Short answer

A 401(k) is an employer-sponsored retirement plan where you contribute pre-tax dollars, your employer often matches, and earnings grow tax-deferred until retirement withdrawal.

How a 401(k) Works

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1. You Contribute
Set aside pre-tax income from your paycheck each month (up to $23,500/year in 2024).
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2. Employer Match
Your employer may match a % of your contribution (e.g., 100% match up to 3% of salary).
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3. Tax-Deferred Growth
Your balance grows without tax liability until you withdraw in retirement.
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4. Retirement Withdrawal
At 59½+, withdraw tax-free growth (with some taxes owed on pre-tax contributions).
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5. Required Distributions
At 73, you must begin Required Minimum Distributions (RMDs).

Step-by-step worked examples

You earn $60,000/year and contribute 5% to your 401(k). Your employer matches 100% up to 3%. How much does the employer add?

Your contribution: 5% × $60,000 = $3,000
Employer match (100% of first 3%): 3% × $60,000 = $1,800
Total for the year: $3,000 + $1,800 = $4,800

Your 401(k) balance is $150,000 at age 60. You withdraw $10,000. Any penalties?

You're 60, under the 59½ rule. Standard rules: early withdrawal penalty = 10% + income tax.
Penalty = 10% × $10,000 = $1,000 (plus income tax on the $10,000)

At 73, your 401(k) has $500,000. Life expectancy factor is 26.5 (IRS table). What's your RMD?

Required Minimum Distribution = Balance / Life expectancy factor
RMD = $500,000 / 26.5 = $18,868.37

Flashcards

Quick quiz

Q1.A 401(k) contribution reduces which tax?

Correct answer: C. Traditional 401(k) contributions are pre-tax, lowering your taxable income and payroll taxes.

Q2.Employer match on a 401(k)...

Correct answer: B. Employer match is additional free money added to your 401(k) account.

Q3.Withdrawing at 45 from a 401(k) typically results in...

Correct answer: B. Early withdrawal (before 59½) incurs 10% penalty + income tax on the amount (with few exceptions).

Q4.Required Minimum Distributions (RMD) start at age...

Correct answer: D. As of 2023, RMDs begin at age 73 (previously 72).

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Common mistakes

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A 401(k) is an investment; it's guaranteed to grow. — Correct: A 401(k) is a savings account type. Growth depends on your investment choices (stocks, bonds, mutual funds).

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You should never withdraw from a 401(k) early. — Correct: Early withdrawal has penalties, but hardship exceptions and 72(t) rules allow penalty-free access in rare cases.

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Employer match is the same for all employees. — Correct: Match formulas vary by employer — some do 100% up to 3%, others 50% up to 6%, or none.

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You must use your 401(k) at retirement. — Correct: You can roll it to an IRA or leave it in the plan (if balance >$5,000). Rolling preserves tax benefits.

FAQ

What is a 401(k)?

A tax-advantaged employer-sponsored retirement savings plan where pre-tax contributions grow tax-deferred.

How much can you contribute to a 401(k)?

2024 limit: $23,500 (under 50) or $30,500 (50+). Catch-up contributions available at 50+.

What's the difference between 401(k) and IRA?

401(k) is employer-sponsored with higher limits and employer match. IRA is individual, no employer involved.

Can you lose your 401(k) if the company goes bankrupt?

No — your 401(k) is legally separated from company assets (ERISA protection).