If you work for an employer that offers a 401(k), you have access to one of the most powerful wealth-building tools available to working Americans. Yet many employees either do not enroll or enroll without understanding what they are doing.
Here is everything you need to know to actually use yours effectively.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement savings account. You contribute a percentage of your paycheck before taxes, the money goes into the account, and it grows invested until you withdraw it in retirement.
The "before taxes" part is significant. If you earn $50,000 per year and contribute 10% ($5,000) to your 401(k), you only pay income taxes on $45,000. This lowers your current tax bill and lets you invest more than if you were saving after-tax dollars.
How Does a 401(k) Actually Work?
When you enroll, you choose what percentage of your paycheck to contribute. Your employer sends that percentage directly to your 401(k) account before you ever see it. You then choose how to invest the money within the account from the options your employer's plan provides.
The money grows tax-deferred inside the account. You pay no taxes on gains while the money is invested. You pay income taxes when you withdraw the money in retirement.
The Employer Match: Free Money You Cannot Ignore
Many employers offer a 401(k) match, where they contribute additional money to your account based on what you contribute. A common structure is a 100% match up to 3% of your salary.
This is free money. If you earn $40,000 and contribute 3% ($1,200), your employer adds another $1,200. Your $1,200 investment immediately becomes $2,400 before any market returns. That is an instant 100% return, which nothing else in finance provides.
2024 Contribution Limits
The IRS limits how much you can contribute to a 401(k). For 2024, employees can contribute up to $23,000 per year. Workers aged 50 and older can contribute an additional $7,500 as a "catch-up" contribution.
These limits apply only to your contributions, not your employer's match. Your employer can contribute on top of the limit.
What Should You Invest In?
Most 401(k) plans offer a menu of mutual funds and sometimes individual stocks. For most employees, the best choice is a low-cost index fund that tracks the total stock market or the S&P 500. Look for funds with low expense ratios (under 0.2% is good, under 0.10% is excellent).
If your plan offers a target-date fund that matches your expected retirement year, that is often the simplest and most sensible option for beginners. The fund automatically becomes more conservative as you approach retirement.
What About Roth 401(k)?
Some employers offer a Roth 401(k) option. Like a Roth IRA, you contribute after-tax dollars, and withdrawals in retirement are tax-free. This is often better for younger workers who are currently in lower tax brackets but expect to be in higher brackets later.
If unsure whether traditional or Roth is better for you, contributing some to each is a reasonable hedge.
What Happens If You Leave Your Job?
Your contributions to a 401(k) are always yours. Employer contributions may be subject to a vesting schedule, meaning you keep a higher percentage the longer you stay.
When you leave a job, you can roll your 401(k) to your new employer's plan or to an IRA. Rolling it over is usually better than cashing it out, which triggers taxes and a 10% early withdrawal penalty if you are under 59 and a half.
Getting Started Today
If you have not enrolled in your employer's 401(k), do it this week. Contact your HR department or check your employee benefits portal. Enroll, contribute at least enough to get the full match, and choose a low-cost index fund or target-date fund as your investment. That one hour of setup can have an enormous impact over your career.