What Is a 401(k)?
A 401(k) is a retirement savings plan offered by many US employers. Employees choose a portion of their pay to be deducted and invested in the plan, and employers may add contributions. The name comes from the section of the US tax code that created it. Similar plans exist under other names, such as 403(b) for nonprofits and schools, and workplace pensions in other countries.
How it works
- Enroll through your employer, or be enrolled automatically with the option to change.
- Choose a contribution rate, a percentage of your pay.
- Select investments from the plan's menu, such as target-date funds, index funds and bond funds.
- Receive any employer match.
- Your account grows through contributions and investment returns.
- Withdraw in retirement, usually after age 59 and a half without penalty.
Contribution limits are set by law and change over time, so check the current figures.
Tax treatment
Traditional 401(k) contributions are usually made before income tax, which lowers your taxable income now. Investments grow tax-deferred, and withdrawals in retirement are taxed as income. Many plans also offer a Roth 401(k), with after-tax contributions and tax-free qualified withdrawals. See our entry on Roth IRA for similar concepts.
Employer match and vesting
A match is often described as, for example, 50 percent of your contributions up to 6 percent of your pay. This is effectively extra compensation. Employer contributions may vest over time, so leaving early may mean forfeiting part of them.
Costs
Plans may charge fees for administration and the funds. Look for low-cost index and target-date funds, and check fund expense ratios.
Tips for new graduates
- Contribute at least enough to get the full match.
- Increase contributions as your income rises.
- Start early, because compound interest rewards long periods of saving.
- Keep investments diversified, and avoid frequent trading.
- Avoid cashing out when you change jobs. Roll the balance over into a new plan or an IRA.
- Keep track of old accounts.
Risks
Investment values can fall, and early withdrawals may incur taxes and penalties. Review your plan and risk tolerance periodically.
Outside the US
Many countries have workplace pensions with automatic enrollment and employer contributions. Rules differ, so look up your local scheme.
Related terms
See Roth IRA, compound interest, benefits package, gross vs net pay and inflation.
Frequently asked questions
What is an employer match?
Money your employer adds to your account when you contribute, often a percentage of your pay up to a limit. It is a valuable benefit, so many people contribute at least enough to receive the full match.
Can I withdraw money from a 401(k) early?
Usually with taxes and often a penalty before a set age, with some exceptions. Treat it as long-term savings, and check plan rules.
What is vesting?
The schedule by which employer contributions become yours. You may need to stay for a certain period to keep all matched money.