What Is a 401(k) and How Does It Work?

A 401(k) is an employer-sponsored retirement account that lets you contribute part of each paycheck before or after taxes, invest that money in funds chosen from a menu your plan provides, and let it grow until retirement. It is worth using if your employer offers one — especially if they match contributions — because the match is compensation you only receive by participating. The main decisions are how much to contribute, whether to use pre-tax or Roth treatment, how to invest, and what to do with the account when you change jobs.

How a 401(k) differs from an IRA or a brokerage account

The practical difference is control versus convenience. A 401(k) gives you automatic payroll contributions and often free money through a match, but a short fund menu. An IRA gives you almost unlimited investment choice but no match and, for most people, a lower annual contribution ceiling. A taxable brokerage account has no contribution limit and no withdrawal restrictions, but no tax break going in or coming out.

How employer matching works

A match is a formula, not a flat bonus. Common structures include:

• Dollar-for-dollar up to a percentage of pay. If your employer matches 100% of contributions up to 4% of salary, contributing 4% earns you the full match.
• Partial match. A 50% match up to 6% of pay means contributing 6% earns a match equal to 3% of your salary.
• Vesting schedules. The match may become yours only after a period of service — for example, a three-year cliff or graded vesting over several years. Your own contributions are always yours.

Because the match is calculated as a percentage of pay, the key number to find in your plan documents is the contribution rate that captures the full amount. Contributing below that rate leaves part of your compensation on the table; contributing above it does not increase the match.

Contribution limits and catch-up contributions

The IRS caps how much you can put into a 401(k) each year, and the cap is higher for people age 50 and older through catch-up contributions. Limits are adjusted periodically for inflation, so check the current figure for the tax year you are contributing in rather than relying on a number you remember. Two things to keep straight:

• The employee elective deferral limit applies to what comes out of your paycheck.
• A separate, higher total limit applies to employee plus employer contributions combined.

If you reach the employee limit before year-end, your payroll system should stop deferrals — but verify this, because over-contributing across two employers in the same year creates a correction problem at tax time.

Pre-tax vs. Roth 401(k)

Many plans now offer both. The trade-off is when you take the tax hit:

• Pre-tax (traditional): Contributions reduce your taxable income now; withdrawals in retirement are taxed as ordinary income.
• Roth: Contributions are made with after-tax dollars; qualified withdrawals in retirement are tax-free.

A rough rule: pre-tax tends to favor people in a higher tax bracket now than they expect in retirement, and Roth tends to favor people early in their careers or expecting higher future tax rates. If your plan allows it, you can split contributions between the two. Also check whether your plan offers an in-plan Roth conversion and whether the match is paid in pre-tax or Roth dollars — the match is often pre-tax regardless of what you elect.

Choosing investments inside the plan

Most 401(k) menus include a mix of target-date funds, index funds, actively managed funds, and a stable-value or money market option. Two common approaches:

• Target-date fund. Pick the fund whose year is closest to your expected retirement year. It automatically shifts toward more conservative holdings as that date approaches. This is the simplest option if you do not want to manage allocations.
• Index funds. Build a mix of broad stock and bond index funds and rebalance periodically. This usually costs less in fees but requires you to choose and maintain the allocation.

The number that matters most beyond your contribution rate is the expense ratio on each fund, since it is deducted from returns every year. A plan with high-cost funds can still be worth using for the match, but it is a reason to contribute up to the match and consider an IRA for additional savings.

Withdrawals, penalties, and RMDs

Money in a 401(k) is intended for retirement, and the tax code enforces that:

• Early withdrawals before age 59½ are generally subject to income tax plus a 10% additional tax, with limited exceptions such as certain hardship rules, disability, or separation from service after age 55 in some plans.
• Required minimum distributions (RMDs) force you to withdraw a minimum amount each year starting at a set age. The age and formula have changed in recent years, so confirm the current rule for your situation.
• Plan loans are allowed by some employers but not all, and an unpaid loan can become a taxable distribution if you leave the job.

What happens when you change jobs

You generally have four choices for an old 401(k):

1. Leave it with the former employer, if the balance is above the plan's minimum.
2. Roll it over to a new employer's 401(k), if that plan accepts rollovers.
3. Roll it into an IRA, which usually widens your investment options.
4. Cash it out, which triggers tax and possibly the 10% penalty — rarely the right move.

A direct rollover — where the money moves between institutions without passing through your hands — avoids mandatory withholding. If a check is made payable to you, the plan is generally required to withhold 20% for taxes even if you intend to redeposit it within 60 days.

A practical starting sequence

1. Find the match formula and vesting schedule in your plan documents.
2. Contribute at least enough to earn the full match.
3. Check the expense ratios on the funds in your menu.
4. Decide between pre-tax and Roth, or split between them.
5. Increase your contribution rate with each raise until you approach the annual limit.
6. When you change jobs, choose a rollover path rather than cashing out.

Yahoo Finance's personal finance coverage, including its retirement and savings reporting, is one place to follow how these rules and limits change from year to year.