A 401(k) is a tax-advantaged retirement savings plan offered by employers in the United States, allowing employees to invest a portion of their salary for long-term growth. Contributions are typically made through payroll deductions, and the funds are invested in options such as mutual funds, stocks, and bonds. One of the key advantages of a 401(k) is its tax benefit—traditional 401(k) contributions are made pre-tax, reducing taxable income.
Two major types of 401(k) plans
There are two major types of 401(k) plans: Traditional 401(k) and Roth 401(k). A Traditional 401(k) allows you to contribute pre-tax income, which reduces your taxable income today. However, withdrawals in retirement are taxed as ordinary income. In contrast, a Roth 401(k) is funded with after-tax contributions, meaning you don’t get an immediate tax break, but qualified withdrawals in retirement are tax-free. The choice between the two depends on whether you expect to be in a higher or lower tax bracket in the future and your preference for upfront tax savings versus tax-free income later.
How 401(k) plans work
A 401(k) plan allows employees to save for retirement by contributing a portion of their salary through automatic payroll deductions. These contributions are invested in options like mutual funds, stocks, or bonds, helping the money grow over time. Many employers also offer matching contributions, boosting savings. In a traditional 401(k), contributions are made pre-tax, reducing current taxable income, while taxes are paid upon withdrawal.
How do you start a 401(k)?
Starting a 401(k) begins with enrolling in your employer’s retirement plan, usually through HR or an online benefits portal. You choose how much of your salary to contribute, often as a percentage, and select investment options such as mutual funds or target-date funds. It’s wise to contribute at least enough to get the full employer match, if offered. Contributions are automatically deducted from your paycheck. You can adjust your contribution rate and investments over time. If your employer doesn’t offer a 401(k), you can consider opening an Individual Retirement Account (IRA) as an alternative way to save for retirement.
401(k) plan contribution limits
401(k) plan contribution limits are set annually by the IRS. For 2024, employees can contribute up to $23,000, with an additional catch-up contribution of $7,500 allowed for those aged 50 and older. These limits apply to the total amount you can defer from your salary into a 401(k) plan. Employer contributions, such as matching, are not included in this individual limit but are subject to a higher combined cap. Contribution limits may change each year based on inflation adjustments, so it’s important to check current IRS guidelines to maximize your retirement savings effectively.
How does your 401(k) earn money?
Your 401(k) earns money through investments such as stocks, bonds, mutual funds, and ETFs. Returns come from market growth, dividends, and interest. Over time, compound growth helps your money increase as earnings generate additional earnings, making long-term investing in a 401(k) a powerful way to build retirement wealth.
When leaving a job, a common question is how long you can keep your 401(k) with your former employer.
How long can you leave a 401(k) with your old company?
In most cases, you can leave your 401(k) with your former employer indefinitely, as long as your account balance meets the plan’s minimum requirement (often $5,000 or more). However, if your balance is below a certain threshold (typically $1,000 or $5,000), the employer may force a distribution—either by cashing it out or rolling it into an IRA on your behalf.
What is the 60-day rollover rule?
The 60-day rollover rule applies when you withdraw funds from your 401(k) and intend to move them into another retirement account, such as an IRA or a new employer’s plan. You must deposit the full amount into the new account within 60 days to avoid taxes and penalties. If you miss this deadline, the withdrawal may be treated as taxable income and, if you are under age 59½, subject to a 10% early withdrawal penalty.
Can you leave your 401(k) with your former employer?
Yes, you can often leave your 401(k) where it is. This may be a good option if the plan offers strong investment choices and low fees. However, you will no longer be able to contribute to the account, and managing multiple retirement accounts over time can become complicated.
What to find out about your 401(k) first
Before making a decision, review key details of your plan:
-Investment options and performance
-Fees and administrative costs
-Employer match (if applicable in a new job)
-Withdrawal rules and flexibility
-Loan provisions (if relevant)
Your main options
1. Keep Your 401(k) Where It Is
This is the simplest option. Your money continues to grow tax-deferred, and you avoid immediate taxes or penalties. However, you may have limited control compared to other options.
2. Roll it over into your new employer’s plan
If your new employer offers a 401(k), you can transfer your old balance into it. This consolidates your savings into one account, making it easier to manage. It also preserves tax advantages and may allow continued borrowing or other plan features.
3. Roll it over into an IRA
Rolling your 401(k) into an Individual Retirement Account (IRA) is a popular choice. IRAs typically offer a wider range of investment options, including stocks, bonds, ETFs, and mutual funds. You also gain greater control over your portfolio and potentially lower fees.
4. Cash out the 401(k)
While this provides immediate access to your funds, it is usually the least advisable option. Cashing out triggers income taxes and, if you are under 59½, an additional 10% penalty. It also reduces your long-term retirement savings.
