Ask a CFP® – Foundational Questions Edition: What’s a 401(k)?
Welcome back to our Account Types Series, part of the Ask a CFP® – Foundational Questions Edition. In this series, we’re breaking down the most common types of investment accounts, and how you might best utilize each one.
Each week, we’ll answer a different account-related question, and this week, we’re starting with a big one: What’s a 401(k)?
We’re covering a wide range of topics on 401(k)s today, from why they exist, how to contribute, investment options, how they impact your taxes, and how to distribute funds someday. At the end, we have a “TL;DR” section to give you the important highlights to know. If you prefer to skip to that section now, feel free to click here.
As a quick reminder, here’s what we’ll be covering in the coming weeks as we build on this foundation:
What’s a 401(k)
What’s an IRA?
What’s the difference between a Traditional and a Roth account?
What’s a taxable brokerage account?
Bonus Question: Should I invest in a 401(k)/IRA/Roth IRA or an index fund?
What is a 401(k)?
At its core, a 401(k) is an investment account offered as a benefit for working for your employer. While not all 401(k)s are created equal, many share a common set of features and, when used well, they can be a powerful tool for compounding wealth over the course of your working years, and funding your desired retirement.
Before we explore the benefits of 401(k)s in more detail, let’s start with a high-level overview of how 401(k)s work.
From Pensions to 401(k)s: A Shift in Retirement Responsibility
Years ago, pensions were the most common form of employer-provided retirement benefits. Pensions are known as a “defined benefit” plan because the benefit itself is defined or known ahead of time. A typical pension might promise something like:
“If you retire at age 62, we’ll pay you $x per month for the rest of your life.”
These defined benefit plans can be great for providing some stability and predictability throughout retirement, but the plans themselves can be a liability for employers as ultimately, they’re responsible for paying out the benefits.
To reduce that burden, many employers shifted toward offering 401(k)s and other “defined contribution” plans. These plans still help employees save for retirement, but the key difference is this:
The responsibility for funding and managing the account shifts from the employer to the employee.
With a 401(k), it’s your responsibility to contribute to the account (though many employers help by offering matching contributions to varying degrees) and you choose how to invest those funds.
Over time, the goal is to build a nest egg you can withdraw from during retirement to help support your lifestyle. This shift in retirement paycheck responsibility from the employer to the employee is a big reason why 401(k)s and other defined contribution plans tend to be among the most common workplace benefits offered.
How do 401(k) Contributions Work?
When you begin working for your employer (or after a required waiting period, depending on the plan), you’ll typically become eligible to participate in the company’s 401(k). Once you're eligible, an account is established in your name. Think of it like a bucket you’ll gradually fill with contributions during your working years and eventually draw from in retirement.
You can choose to contribute either a fixed dollar amount or a percentage of your paycheck. Most commonly, contributions are made as a percentage of pay deducted automatically each pay period. Instead of landing in your bank account, those dollars are directed into your 401(k) account and invested according to the strategy you've selected.
How Much Can You Contribute?
There are annual limits on how much you can contribute to your 401(k). For 2025, most employees can contribute up to:
$23,500 if you're under age 50
$31,000 if you're age 50–59 or 64+ (includes a $7,500 “catch-up” contribution)
$34,750 if you're age 60–63 (includes an $11,250 enhanced “catch-up” contribution)
Note: These limits apply to employee contributions only. Business owners and highly compensated employees may face additional plan-specific rules or limitations.
In addition to your own contributions, your employer may also contribute to your account, either through a match, profit-sharing, or other employer-based formula. However:
Employer contributions generally can’t exceed 25% of your compensation, and
The total annual contributions to your 401(k)—including yours and your employer’s—can’t exceed $70,000 plus any allowable catch-up contributions.
Another Quick Note: Technically you can contribute even more than the employee contributions listed above by using “After-Tax” contributions. We’ll cover these in a future post.
What Investments Can I Choose From in a 401(k)?
Most 401(k) plans will have a variety of mutual funds available for you to choose to invest in. These investment options typically fall into one of a few broad categories including:
· Stocks – These funds invest in companies and typically carry more short-term volatility, but also offer higher long-term growth potential.
· Fixed Income/Bonds – These funds lend money to governments or corporations. Bonds, especially short and intermediate-term bonds, tend to be less volatile than stocks but also generally offer more moderate expected returns.
· Cash/Stable Value/Money Market - These are conservative investments that prioritize capital preservation, but offer the lowest long-term growth potential.
None of these categories is inherently “better” than the others. The right mix depends on your time horizon, goals, and risk tolerance. Additionally, the specific fund options offered by each 401(k) can vary in quantity, quality, and cost. That’s why aligning your investments with your overall financial plan is so important.
If investing isn’t your area of expertise (and that’s totally normal), many 401(k)s offer target-date funds to simplify the process.
What’s a Target-Date Fund?
A target-date fund is a diversified portfolio designed for someone planning to retire around a specific year—for example, a "2040 Target Date Fund." These funds automatically adjust their asset mix over time, typically becoming more conservative as you approach your retirement date. This built-in glide path helps reduce sequence of returns risk (more on that in a future post).
While target-date funds aren’t right for everyone (we typically don’t recommend them once you’re approaching or in the distribution phase of your retirement) they can be a helpful tool for those looking to automate their investments for years while they accumulate funds in their account.
How is a 401(k) Taxed?
We’re going to save most of this discussion for our upcoming post on Traditional vs. Roth accounts. But for now, it’s important to know a few things about the taxation of 401(k)s.
1. You get to choose when you want to pay taxes.
Most 401(k) plans allow you to contribute in one of two ways:
· Traditional 401(k): You contribute pre-tax dollars, which means you lower your taxable income today. Later, when you take distributions in retirement, those withdrawals will be taxed as ordinary income.
· Roth 401(k): You contribute after-tax dollars, meaning you pay income tax on the funds now. In return, your future withdrawals, including growth, can be tax-free if certain requirements are met.
We’ll break down the pros and cons of each approach when we explore the difference between Traditional and Roth accounts.
2. No taxes on growth while your money stays invested.
No matter which type of 401(k) you choose:
· You won’t pay taxes on dividends, interest, or capital gains while your money remains inside the account.
· Your investments can grow tax-deferred (Traditional) or tax-free (Roth), depending on the type of contributions you’ve made.
This is one of the key benefits of a 401(k): the power of compounding without the drag of annual taxes.
Why Would I Choose to Participate in a 401(k)?
While not all 401(k) plans are created equal, many offer compelling benefits that can make them an excellent foundation for your retirement strategy. Here are a few reasons why:
1. Simplicity and Ease of Use – Let’s be honest, investing can feel overwhelming, especially if it’s new to you. A 401(k) offers a streamlined, automated way to get started. Once you set your contribution amount, savings are deducted from your paycheck and invested automatically. Over time, this simple system can provide a comfortable retirement when paired with other assets and income sources.
2. Employer matching contributions – Many employers offer matching contributions to your 401(k)s where they’ll agree to contribute a certain percentage of your pay to your account, if you also agree to contribute a certain percentage. The calculations to determine the match can vary, and sometimes (but not always) you have to continue working for that employer for a number of years before you’re fully vested (meaning you fully own the rights to the contributions the employer made), but a match is essentially free money. If you contribute 4% to your 401(k) and then your employer matches you and also contributes 4%, that’s an immediate 100% return on your investment, which is otherwise nearly impossible to come by in the investment world without taking on very high levels of risk.
3. Tax benefits – See above and see our future post on Traditional vs. Roth accounts
Is My Money Stuck in a 401(k) Forever?
Nope, not forever. While 401(k)s are designed for long-term retirement savings and are generally intended to be left alone until at least age 59½, that doesn’t mean your money is completely locked away.
Life happens. And in some cases, you may need or want to access your funds earlier. Fortunately, there are several ways you might be able to tap into your 401(k) before retirement age.
We'll go deeper into these strategies in future posts, but for now, it’s helpful to know that options exist. As always, we recommend working with a financial professional before making any early withdrawal decisions—they can help you weigh the tradeoffs and avoid costly penalties or unintended tax consequences.
If you’re still working, your employer may allow:
· Hardship withdrawals – for things like medical expenses, funeral costs, or avoiding eviction.
· In-service distributions – available in some plans if you meet certain age or tenure requirements.
· 401(k) loans – borrowed from your own balance and typically repaid with interest (though there are risks if you leave your job before repaying).
And once you retire or leave your job, you may be able to use strategies like:
· The Rule of 55 – allows penalty-free withdrawals if you leave your job after age 55 (age 50 for some public service workers).
· 72(t) distributions – also called Substantially Equal Periodic Payments, these allow penalty-free withdrawals if taken in a strict schedule over time.
· Roth conversion ladders – a strategy to convert Traditional 401(k) funds to Roth IRAs over time, then access contributions penalty-free after 5 years.
Each strategy comes with its own set of rules, risks, and potential tax implications, so due diligence is key.
What Happens to my 401(k) if I Change Jobs?
Since 401(k)s are tied to your employer, it’s common to wonder what happens to your account if you change jobs. The good news: your money doesn’t disappear, and in most cases, you’ll still own all (or most) of the funds in your account. You typically have several options:
· Rollover to an IRA:
We’ll explore IRAs in more detail next week, but here’s the short version: you can open a personal IRA and do a direct rollover from your 401(k) into it. As long as you transfer between similar account types (e.g., Traditional 401(k) to Traditional IRA), there are no immediate tax consequences, and your investments can continue to grow tax-deferred.
· Transfer to Your Next 401(k):
If your new employer offers a 401(k), you may be able to roll your old 401(k) into the new plan. Not every plan allows incoming transfers, so it’s important to check. This isn’t for everyone, as sometimes your new 401(k) may have higher fees or fewer investment options than you’re comfortable with, so it’s important to do some due diligence. However, there can be multiple advantages to taking this step including:
o Simplification – Fewer accounts means less to manage. (Believe it or not, we’ve seen clients forget they had an old 401(k) entirely.)
o Rule of 55 Eligibility – For those that plan to retire prior to age 59 ½, rolling funds into your new 401(k) can help if you’d like to use the Rule of 55 for penalty-free withdrawals (and your new plan allows for this).
o Backdoor Roth IRA Considerations – Without diving into the weeds just yet: holding pre-tax money in a Traditional IRA can complicate backdoor Roth IRA strategies. Keeping your funds in a 401(k) instead can help preserve that planning option.
· Leave It Where It Is – In most cases, you’re not required to move your 401(k) when you leave a job. If the plan offers solid investment options and low fees, it may be perfectly fine to leave it where it is, especially if you want to avoid unnecessary transactions.
A Quick Word on Vesting
When you leave an employer, you always own 100% of the money you contributed to your 401(k), plus any earnings.
But for employer contributions, things get a little more nuanced. Most plans use a vesting schedule to determine how much of the employer match you get to keep when you leave. For example:
· Some plans use a 3-year cliff vesting schedule—if you leave before 3 years, you lose the match. Stay 3+ years, and you keep 100%.
· Others may “grade” the vesting, giving you a larger percentage each year you remain with the company.
This is important to know when weighing job changes. If you’re close to being fully vested, sticking it out a few more months might mean keeping thousands in matched contributions.
When Do I Have to Distribute Funds from my 401(k)?
One final, but important, point about 401(k)s is that if you have any funds in a Traditional 401(k) (and most people do, especially when employer contributions are involved), there will come a time when you’re required to distribute funds from the account and pay income tax on your distributions.
When do RMDs begin?
The age at which these required minimum distributions or “RMDs” begins depends on your age:
· Age 73 for those born between 1950-1959
· Age 75 for those born in 1960 going forward
RMD rules apply to the Traditional portion of your 401(k). If you also have Roth contributions in the same plan, they may be treated differently depending on plan design and the year you retire (more on that in a future post).
How Are RMDs Calculated?
Each year, the amount you’re required to withdraw is based on a formula:
· It uses your 401(k) balance as of December 31st of the previous year
· Divided by a life expectancy factor published by the IRS
At age 73, your first RMD will typically be just under 4% of your total account balance. That percentage increases over time as the IRS factor decreases.
Example:
Let’s say your 401(k) balance on December 31st is $800,000 and your age factor is 26.5.
Your RMD would be approximately:
$800,000 ÷ 26.5 = $30,189 (which would be taxed as ordinary income)
Can I Take Distributions Earlier?
Of course. You’re welcome to start taking distributions before your RMD age—many people do as part of a long-term tax strategy or income plan. But RMD age is the point at which you must begin taking withdrawals—unless:
· You're still working for the employer sponsoring your 401(k), and
· You don’t own more than 5% of the business
This “still working” exception applies only to the current employer’s plan, not to old 401(k)s or IRAs.
TL;DR
· A 401(k) is a workplace retirement account—a “container” where your investments can grow until you’re ready to retire.
· They offer several potential benefits, including simplicity, tax advantages, and often free money through an employer match.
· Contribution limits apply: For 2025, most people can contribute between $23,500 and $34,750 depending on age.
· If you leave your job, your money doesn’t vanish—most or all of your balance is typically still yours, and you’ll have several rollover options.
· Eventually, you’ll be required to begin taking withdrawals from your Traditional 401(k). This starts at age 73 or 75 depending on your birth year.
Summary and Looking Ahead
We hope this guide helped demystify 401(k)s and shed light on some of their key features including why they exist, how they work, and why they’re often a cornerstone of a strong retirement plan.
If you have questions about your own 401(k) and how it fits into your bigger financial picture, and you’re wondering if we might be a good fit to help, reach out through our Contact page to schedule a quick introductory call. We’d be happy to connect.
Have a question you’d like us to cover in a future post? Send it to ask@sandersretirement.com, and we’ll do our best to include it in the series.
Next week, we’re diving into another common (and often misunderstood) retirement account: the IRA. Stay tuned!