How a 401(k) Works: Contributions, Growth, and Withdrawals

How money moves into and out of your 401(k)

A 401(k) is a retirement account your employer sponsors. You contribute money from your paycheck before taxes are taken out (in a traditional 401(k)) or after taxes (in a Roth 401(k)). Your employer may match part of what you contribute. The money sits in the account, grows through investments you choose, and you withdraw it in retirement, usually starting at age 59½.

The account is held in your name but managed through your employer's plan. Your employer picks the plan provider—often a company like Fidelity, Vanguard, or Schwab—and that provider holds the money, tracks your balance, and lets you choose how to invest it. You never touch the cash directly; it flows from payroll to the plan provider automatically.

Key Takeaways

• Money goes into your 401(k) through automatic payroll deduction, and your employer may add matching contributions up to a set percentage of your salary.
• You choose how to invest the money from a menu of mutual funds and other options the plan offers, and your balance grows or shrinks based on how those investments perform.
• You cannot withdraw money before age 59½ without paying a 10% penalty plus income tax, except in narrow situations like hardship or separation from your job.
• The IRS sets annual contribution limits (which change yearly) and requires you to start taking withdrawals at age 73, whether you need the money or not.
• A Roth 401(k) uses after-tax dollars but lets you withdraw earnings tax-free in retirement, while a traditional 401(k) defers taxes until you withdraw.

Contribution limits and how much you can put in each year

The IRS sets a maximum amount you can contribute to your 401(k) each year. That limit changes annually and applies to the total of all 401(k)s you own—if you work two jobs with two 401(k)s, your combined contributions cannot exceed the limit. Your employer's matching contribution does not count toward your personal limit, but it does count toward a higher combined limit that includes both employee and employer money.

You set your contribution rate as a percentage of your paycheck when you enroll or during your employer's annual open enrollment period. If you contribute 6% of a $50,000 salary, that is $3,000 per year, or about $250 per month. Your payroll department deducts that amount before calculating your taxes, which is why it lowers your taxable income for the year.

If you are age 50 or older, the IRS allows you to contribute an additional amount called a catch-up contribution. This is a separate limit and is meant to help people save more in the years before retirement.

Employer matching and how to capture assistance programs

Many employers offer to match your contributions—usually up to a certain percentage of your salary. A common match is 50% of what you contribute, up to 6% of your pay. That means if you contribute 6% of your salary, your employer adds 3% on top. If you contribute only 2%, they add only 1%.

The match is not automatic; you have to contribute first for your employer to add theirs. If your employer offers a match and you do not contribute, you lose that money. It does not roll over or come back later. This is why financial advisors often say to contribute at least enough to get the full match—it is immediate, may provide return on your money.

The match goes into your 401(k) account alongside your own contributions and is invested the same way. You own it immediately in most plans, meaning you keep it even if you leave the job, though some employers require you to stay a certain number of years to keep the match (called vesting).

How your money is invested and what choices you have

When money lands in your 401(k), it does not sit in cash. You must choose how to invest it from a menu of options your plan offers. Most plans offer mutual funds—baskets of stocks, bonds, or both—and many offer target-date funds, which automatically shift from stocks to bonds as you approach retirement.

You can usually split your contributions across multiple funds. For example, you might put 60% into a stock fund and 40% into a bond fund. You can change these choices whenever you want, though most people change them only once or twice a year. Your employer's plan provider shows you the historical performance of each fund, but past performance does not predict future results.

Some plans offer a self-directed brokerage option, which lets you buy individual stocks or bonds instead of just mutual funds, but this is less common. A few plans offer company stock as an investment choice, which means you can own shares of your employer. This carries extra risk because your paycheck and your retirement savings both depend on the same company.

Traditional versus Roth: the tax difference

A traditional 401(k) uses pre-tax dollars. You contribute before income tax is withheld, which lowers your taxable income for the year. When you withdraw the money in retirement, you pay income tax on it then. This works well if you expect to be in a lower tax bracket in retirement than you are now.

A Roth 401(k) uses after-tax dollars. You contribute money that has already been taxed as income. In retirement, you withdraw the money tax-free—both what you put in and the growth. This works well if you expect to be in a higher tax bracket in retirement, or if you simply want to lock in today's tax rate and avoid uncertainty about future rates.

Some employers offer both types in the same plan. You can split your contributions between them if you want. The annual contribution limit applies to the combined total of traditional and Roth contributions, not to each separately. Employer matching contributions always go into a traditional account, even if you contribute to a Roth.

When you can withdraw money and what happens if you withdraw early

You can withdraw money from your 401(k) starting at age 59½ without penalty. Before that age, withdrawals are subject to a 10% early withdrawal penalty plus income tax on the amount you take out. A $10,000 withdrawal at age 45 could cost you $1,000 in penalty plus income tax, leaving you with significantly less than $9,000.

There are narrow exceptions to the early withdrawal penalty. You can withdraw without penalty if you separate from your job in the year you turn 55 or later (this rule does not apply to IRAs). You can also withdraw without penalty for certain hardships—birth or adoption of a child, medical expenses, home purchase, or prevention of eviction or foreclosure—though you still pay income tax. Some plans allow loans instead of withdrawals, letting you borrow from your own account and pay yourself back with interest.

Once you turn 73, the IRS requires you to take a minimum withdrawal each year, whether you need the money or not. This is called a required minimum distribution (RMD). The amount is calculated based on your age and account balance. If you do not take it, you owe a penalty on the amount you should have withdrawn.

What happens to your 401(k) when you leave your job

When you leave your job, your 401(k) stays in your former employer's plan unless you move it. You have several options: leave it where it is, roll it into your new employer's plan (if they accept rollovers), roll it into an individual retirement account (IRA), or cash it out. Cashing it out triggers the 10% early withdrawal penalty and income tax if you are under 59½, so it is rarely the best choice.

A rollover moves money from one retirement account to another without triggering taxes or penalties, as long as you follow the rules. A direct rollover goes straight from your old plan to the new account; an indirect rollover sends the money to you first, and you have 60 days to deposit it in a new account or it becomes taxable. Most people choose a direct rollover to avoid the risk of missing the deadline.

If you leave money in your old employer's plan, you can still access it at 59½ without the early withdrawal penalty (the 55-or-older separation rule does not apply). You can also take a loan from it if the plan allows. However, you lose the ability to contribute more, and you may pay higher fees than if you rolled it to an IRA or your new employer's plan.

Fees and what they cost you over time

401(k) plans charge fees in several ways. The plan itself may charge an administrative fee to cover record-keeping and customer service. Individual funds charge expense ratios—a percentage of your balance charged annually to cover the cost of managing that fund. Some plans charge per-transaction fees for loans or rollovers.

Fees vary widely between plans. A plan with low-cost index funds might charge 0.05% per year in expense ratios, while a plan with actively managed funds might charge 0.75% or more. Over 30 years, the difference compounds significantly. A $100,000 balance growing at 7% per year costs you roughly $1,500 more in total growth if you pay 0.75% in fees instead of 0.05%.

You can see your plan's fees in the Summary of Material Modifications (SMM) document your employer is required to provide, or in the fund fact sheets available through your plan provider's website. If your plan charges high fees, you may have limited control—you cannot switch providers—but you can choose lower-cost funds within the menu offered.

Frequently Asked Questions

Can I contribute to a 401(k) and an IRA in the same year?

Yes. Your 401(k) contributions and IRA contributions are separate limits. However, if you have a traditional IRA and earn too much income, your IRA contributions may not be tax-deductible. A Roth IRA has income limits that may prevent you from contributing at all. Your 401(k) has no income limit.

What happens to my 401(k) if I get fired or laid off?

Your 401(k) is yours to keep. Your employer cannot take it back. You can leave it in the plan, roll it to an IRA, or roll it to your new employer's plan. If you are under 59½, you can withdraw without the early withdrawal penalty if you separate from your job at age 55 or later.

Can I borrow from my 401(k)?

Many plans allow loans, but not all. If yours does, you can usually borrow up to 50% of your balance, up to $50,000. You repay the loan through payroll deductions with interest. If you leave your job before repaying, the loan becomes a withdrawal and is subject to the 10% early withdrawal penalty if you are under 59½.

Do I have to invest in stocks, or can I keep my 401(k) in cash?

Most plans do not offer a cash option. You must choose from the funds available. If your plan offers a stable value fund or money market fund, those are the closest to cash, though they still earn a small return. Keeping everything in the most conservative option means slower growth but less risk of loss.

What if my employer does not offer a 401(k)?

You can open an individual retirement account (IRA) on your own through a bank, brokerage, or investment company. An IRA has lower contribution limits than a 401(k), but you have more control over investments and fees. Some self-employed people or small business owners can set up a SEP-IRA or Solo 401(k) instead.