What Is a 401(k)?
A 401(k) is an employer-sponsored defined-contribution retirement savings plan that allows employees to invest a portion of their paycheck before taxes are taken out. The name comes from the section of the Internal Revenue Code that governs it. Contributions reduce your taxable income in the year made, investments grow tax-deferred, and withdrawals in retirement are taxed as ordinary income.
The 2024 IRS contribution limit is $23,000 for employees under 50, and $30,500 for those 50 and older (including a $7,500 catch-up contribution). These limits apply only to your elective deferrals — employer contributions are separate and can bring the combined total up to $69,000 in 2024.
How Employer Matching Works
Employer matching is effectively free money — one of the best returns available in personal finance. A common structure is a "50% match up to 6% of salary": if you earn $75,000 and contribute 6% ($4,500), your employer adds 3% ($2,250) for a total of $6,750 going into your account. Contributing less than the amount required to capture the full match is leaving guaranteed compensation on the table. Always contribute at least enough to receive the maximum employer match before directing money elsewhere.
The Power of Starting Early
Time is the most powerful variable in 401(k) growth. Consider two investors who both earn 7% annually: Investor A contributes $500/month from age 25 to 65 (40 years) and accumulates approximately $1.32 million. Investor B waits until 35 and contributes $500/month to 65 (30 years), accumulating roughly $609,000 — less than half as much despite contributing for 10 fewer years. The decade of additional compounding more than doubles the outcome.
Investment Allocation and Return Rate
The expected return rate depends heavily on how your 401(k) is invested. Target-date funds — the default option in many plans — automatically shift from stock-heavy to bond-heavy allocations as you approach retirement. A 100% equity allocation in a broadly diversified fund has historically returned roughly 7% annually in real (inflation-adjusted) terms. A balanced stock/bond portfolio typically targets 5–6% real returns. More conservative allocations return less but with lower volatility.
Traditional vs Roth 401(k)
Many employers now offer a Roth 401(k) option alongside the traditional pre-tax version. With a Roth 401(k), contributions are made with after-tax dollars, but qualified withdrawals in retirement are completely tax-free — including all the growth. The same contribution limits apply to both. The right choice depends on whether your tax rate is likely to be higher now (favor traditional) or higher in retirement (favor Roth). Younger workers in lower tax brackets often benefit most from Roth contributions.
Required Minimum Distributions
Traditional 401(k) accounts are subject to Required Minimum Distributions (RMDs) starting at age 73 (as of 2023, per the SECURE 2.0 Act). The IRS requires you to withdraw a minimum amount each year, calculated based on your account balance and life expectancy. Roth 401(k)s are also subject to RMDs unless rolled over to a Roth IRA before distributions begin. Failing to take required distributions results in a 25% excise tax on the amount not withdrawn.