How a 401(k) works

A 401(k) is a retirement savings account that some employers offer to their workers. Money goes in straight from your paycheck, you choose from a list of investments the plan offers, and it stays in the account until you take it out, usually in retirement.

This lesson covers how contributions happen, how the two tax treatments differ, what a match and vesting mean, and what generally happens if you take money out early. Not every employer offers a plan, and plans differ from one employer to another, so what follows describes 401(k) plans in general rather than any particular one.

Money goes in from your paycheck

You choose what percentage of your pay, or what dollar amount, goes to the plan, and some plans start you at a default rate that you can change. That amount comes out of each paycheck before you ever see it and is deposited into your account. This is called a contribution, or an elective deferral.

The money is then invested in the choices the plan offers, often pooled funds such as mutual funds, which hold many stocks or bonds at once. Those investments can lose value, and the plan and the funds inside it charge fees that come out of your account and reduce what you keep. A 401(k) is a container rather than an investment itself, so your risk depends on what you hold inside it.

The IRS caps how much of your own pay you can put in each year. For 2026, the limit is $24,500. Money your employer adds does not count against that employee limit, and separate rules apply to workers age 50 and over.

Traditional and Roth contributions are taxed at different times

Plans offer traditional contributions, and some also offer a Roth option. The difference is when you pay income tax.

Traditional contributions come out of your pay before federal income tax is calculated, so they lower your taxable income for that year. You pay ordinary income tax later, when you withdraw the money.

Roth contributions come out of pay that has already been taxed, so they do not lower this year's tax bill. In exchange, qualified withdrawals of both the contributions and the investment earnings are free of federal income tax. A withdrawal is qualified once you are at least 59 and a half and at least five years have passed since your first Roth contribution to the plan.

Which one fits depends on your tax situation now and later, which nobody can know precisely. A licensed tax professional can help with your own numbers.

An employer match is money added on top of yours

Some employers add money to your account based on what you contribute. This is called a match, and the formula is written in the plan documents.

Here is one shape of formula. Suppose you earn $40,000 a year and the plan matches 50 cents for every dollar you contribute, up to 6 percent of your pay.

Contributing 6 percent means $2,400 of your own money over the year. Your employer adds half of that, $1,200, so the account receives $3,600.

If you contribute 3 percent instead, that is $1,200 from you and $600 from your employer. If you contribute nothing, the employer adds nothing. Contributing more than 6 percent may be allowed, but the match stops growing there.

Match formulas vary widely, and some employers offer no match. To find yours, read the plan's summary plan description, which the plan must give you.

Vesting decides when the employer's money is really yours

The money you contribute from your own pay is always fully yours, immediately. Employer contributions can work differently. Vesting is the process of earning full ownership of employer contributions by staying at the job for a set period.

Some plans vest employer money right away. Others use a schedule where you own a growing percentage for each year you stay, or one where you own none of it until you pass a set number of years and then own all of it. If you leave before you are fully vested, you keep your own contributions and their earnings and give up the unvested employer portion.

Taking money out before 59 and a half usually costs extra

The tax rules push you to leave the money alone until retirement. If you withdraw before age 59 and a half, the taxable part is generally subject to a 10 percent additional tax, on top of the ordinary income tax you owe on it.

Exceptions to that additional tax exist, and separate rules govern when a plan permits a withdrawal while you still work there. Later lessons and IRS materials cover those. When you leave the job, the account stays yours, and you can generally move it to a new employer's plan or to an individual retirement account that you open yourself.

What to remember

• A 401(k) is an employer-offered retirement account funded from your paycheck; not every employer has one, and plan features differ.
• For 2026, the IRS limit on employee contributions is $24,500.
• Traditional contributions lower your federal income tax now and are taxed when withdrawn; Roth contributions are taxed now, and qualified withdrawals are tax free.
• A match is employer money added under a formula, and vesting rules may require you to stay a set time to keep it.
• Withdrawals before age 59 and a half generally face a 10 percent additional tax plus regular income tax, with limited exceptions.