A 401(k) is likely the most valuable financial benefit your employer offers—and it's often underutilized. This tax-advantaged retirement account can help you build substantial wealth while reducing your current tax bill. The key is understanding how to use it effectively.
This guide covers everything you need to know about 401(k) plans, from contribution limits to investment strategies.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that lets you invest a portion of your paycheck before taxes (Traditional) or after taxes (Roth). The money grows tax-advantaged until you withdraw it in retirement.
The name comes from Section 401(k) of the Internal Revenue Code, which established these plans in 1978. Today, 401(k)s are the most common type of workplace retirement plan in America.
Why 401(k)s Are So Powerful
- Tax advantages: Contributions reduce your taxable income (Traditional) or grow tax-free (Roth)
- Employer matching: Many companies contribute additional money to your account
- Automatic savings: Money is deducted from your paycheck before you can spend it
- High contribution limits: You can save significantly more than in an IRA
- Compound growth: Your investments grow for decades until retirement
đź’ˇ Pro Tip: A 401(k) is often the foundation of a strong retirement plan. Most financial advisors recommend contributing at least enough to capture your full employer match before funding other investment accounts.
2025 Contribution Limits
The IRS sets annual limits on how much you can contribute to your 401(k). For 2025:
| Age Group | Employee Contribution Limit | Total Limit (with Employer Match) |
|---|---|---|
| Under 50 | $23,500 | $70,000 |
| 50-59 | $31,000 (includes $7,500 catch-up) | $77,500 |
| 60-63 | $34,750 (enhanced catch-up) | $81,250 |
| 64+ | $31,000 | $77,500 |
What's new in 2025: The SECURE 2.0 Act introduced a higher catch-up contribution limit for those ages 60-63, allowing them to save an additional $11,250 instead of the standard $7,500.
For 2026, the standard limit rises to $24,500, with the 50+ catch-up increasing to $8,000.
đź“Ś Key Takeaway: These limits include only your contributions. Your employer's match doesn't count against your limit, which is why the total limit is much higher.
The Employer Match: Don't Leave Money on the Table
Many employers match a portion of your 401(k) contributions. This is essentially free money—an instant return on your investment that you won't find anywhere else.
Common Match Formulas
| Match Type | What Employer Contributes | You Contribute 6% of $60,000 Salary |
|---|---|---|
| Dollar-for-dollar up to 3% | 100% of first 3% | $3,600 + $1,800 match = $5,400 |
| 50 cents per dollar up to 6% | 50% of first 6% | $3,600 + $1,800 match = $5,400 |
| Dollar-for-dollar up to 6% | 100% of first 6% | $3,600 + $3,600 match = $7,200 |
How to Calculate Your Match
Let's say your employer matches "50% of contributions up to 6% of salary" and you earn $70,000:
- 6% of your salary = $4,200
- Employer matches 50% of that = $2,100
- You must contribute at least $4,200 to get the full $2,100 match
If you only contribute 3% ($2,100), you'd only get $1,050 in matching—leaving $1,050 on the table.
⚠️ Warning: According to Fidelity, about 1 in 5 workers don't contribute enough to capture their full employer match. Over a career, this can cost tens of thousands of dollars.
Understanding Vesting Schedules
"Vesting" determines when you fully own your employer's matching contributions. Your own contributions are always 100% yours immediately—but employer matches often vest over time.
Common Vesting Schedules
| Type | How It Works |
|---|---|
| Immediate vesting | You own 100% of the match right away |
| Cliff vesting | 0% until a specific date (usually 3 years), then 100% |
| Graded vesting | Gradual ownership (e.g., 20% per year for 5 years) |
Example graded vesting schedule:
| Years of Service | Percent Vested |
|---|---|
| 1 year | 20% |
| 2 years | 40% |
| 3 years | 60% |
| 4 years | 80% |
| 5 years | 100% |
đź’ˇ Pro Tip: Check your vesting schedule before leaving a job. If you're close to a vesting milestone, it might be worth staying a few extra months to secure that money.
Traditional 401(k) vs. Roth 401(k)
Most employers now offer both Traditional and Roth 401(k) options. The choice affects when you pay taxes on your money.
| Feature | Traditional 401(k) | Roth 401(k) |
|---|---|---|
| Contributions | Pre-tax (reduces current taxable income) | After-tax (no immediate tax benefit) |
| Growth | Tax-deferred | Tax-free |
| Withdrawals in Retirement | Taxed as ordinary income | Completely tax-free |
| Best If You Expect | Lower tax rate in retirement | Higher tax rate in retirement |
| Required Minimum Distributions | Yes, starting at age 73 | No longer required (as of 2024) |
Which Should You Choose?
Choose Traditional if:
- You're in a high tax bracket now
- You expect lower income in retirement
- You need the tax deduction this year
Choose Roth if:
- You're early in your career with lower income
- You expect higher taxes in the future
- You want tax-free income in retirement
- You want to avoid required minimum distributions
Not sure? Many people split contributions 50/50 between Traditional and Roth. This provides tax diversification—you'll have flexibility to draw from either account based on your tax situation in retirement.
đź“Ś Key Takeaway: There's no wrong choice. Both options provide valuable tax advantages. The important thing is contributing consistently.
Choosing Your Investments
Your 401(k) is just a container—you need to select investments within it. Most plans offer these options:
Target-Date Funds
A target-date fund (also called a "lifecycle fund") automatically adjusts its investment mix as you approach retirement. You pick the fund closest to your expected retirement year (e.g., "Target 2055" if you plan to retire around 2055).
Pros:
- Completely hands-off
- Automatic rebalancing
- Appropriate asset allocation for your age
Cons:
- Less control over investments
- May have higher fees than index funds
Index Funds
Index funds track a market benchmark like the S&P 500. They offer broad diversification at very low cost.
Common index fund options:
- S&P 500 index (large U.S. companies)
- Total stock market index (all U.S. stocks)
- International stock index (non-U.S. stocks)
- Bond index (fixed income)
Actively Managed Funds
Fund managers actively pick stocks trying to beat the market. These typically have higher fees and often underperform index funds over time.
đź’ˇ Pro Tip: Look for funds with expense ratios below 0.5%. Index funds often charge 0.03%-0.20%, while actively managed funds may charge 1% or more. Over decades, these fees significantly impact your returns.
What to Do When You Leave a Job
When you change employers, you have four options for your 401(k):
| Option | Pros | Cons |
|---|---|---|
| Leave it | Simple, no action needed | Multiple accounts to track; limited investment options |
| Roll to new employer's 401(k) | Consolidates accounts | Depends on new plan's quality |
| Roll to an IRA | More investment choices; potentially lower fees | Requires opening an IRA |
| Cash out | Immediate access to money | Taxes + 10% penalty + lost growth |
The Rollover Process
A rollover moves your 401(k) money to another retirement account without triggering taxes or penalties:
- Direct rollover (recommended): Money transfers directly from old plan to new account
- Indirect rollover: You receive a check and have 60 days to deposit it into another retirement account
⚠️ Warning: Cashing out your 401(k) is almost never the right choice. On a $50,000 balance, you'd lose approximately $15,000-$20,000 to taxes and penalties—plus decades of compound growth on that money.
Common 401(k) Mistakes to Avoid
1. Not Contributing Enough to Get the Full Match
This is the single biggest mistake. If your employer offers a 50% match and you don't contribute enough to get it, you're giving away free money.
2. Cashing Out When Changing Jobs
Early withdrawal means losing 20-40% to taxes and penalties immediately, plus all future growth on that money.
3. Being Too Conservative When Young
If you're decades from retirement, you can afford more stock exposure. Being too conservative early means missing out on growth.
4. Not Increasing Contributions Over Time
As your salary grows, increase your contribution percentage. Many plans offer automatic escalation features.
5. Ignoring Investment Fees
A 1% fee difference doesn't sound like much, but over 30 years it can cost you hundreds of thousands of dollars.
6. Taking a 401(k) Loan
While technically allowed, 401(k) loans remove money from the market, potentially costing you significant growth. They also become due immediately if you leave your job.
Maximizing Your 401(k): A Step-by-Step Approach
Step 1: Contribute Enough to Get the Full Match
This is priority number one. It's an instant 50-100% return.
Step 2: Consider Maxing Out
If you can afford it, aim to contribute the full $23,500 (or $31,000 if 50+). This provides maximum tax advantages and accelerates wealth building.
Step 3: Choose Low-Cost Investments
Select index funds or target-date funds with expense ratios below 0.5%.
Step 4: Set Up Automatic Escalation
Many plans let you automatically increase your contribution by 1% each year until you reach your goal.
Step 5: Review Annually
Check your asset allocation, rebalance if needed, and ensure you're on track for your goals.
Your Action Plan
- Check your current contribution rate: Are you getting the full employer match?
- Review your vesting schedule: Know when you fully own your employer contributions
- Examine your investment choices: Look for low-cost index funds or an appropriate target-date fund
- Set up automatic escalation: Increase contributions by 1% each year
- Keep it simple: A single target-date fund or three-fund portfolio (U.S. stocks, international stocks, bonds) is all most people need
Your 401(k) is one of the most powerful wealth-building tools available. Use it wisely, and your future self will thank you.