What Is a 401(k)? Everything You’ve Always Wondered, Explained

Let’s be real: The term “401(k)” sounds like it belongs in a spy movie codebook, not your retirement plan. But here’s the thing—it’s one of the most important tools you’ll ever use to build financial security for your future. 

Whether you’re just starting to think about retirement or you’ve been contributing for years (and maybe even have a vague idea of what’s in your account), you probably have questions. 

What is a 401(k)? How does it work? And why does everyone keep talking about it like it’s the golden ticket to retirement?

Don’t worry—we’re here to break it all down for you. No jargon, just straight-up answers to all your 401(k) questions. Consider this your ultimate guide to understanding your 401(k), whether you’re a newbie or just need a refresher.

What is a 401(k)—and why should you care?

A 401(k) is a retirement savings plan offered by employers in the U.S. Think of it as a special savings account where you stash away a portion of your paycheck before taxes are taken out. The money you contribute gets invested in assets like stocks, bonds, or mutual funds, and over time, it grows (thanks to the magic of compound interest).

Another perk: You don’t pay taxes on that money until you withdraw it in retirement. That’s right—your 401(k) is like a financial time capsule that lets your money grow tax-free until you’re ready to use it.

About that name: Why is it called a 401(k)? It comes from a section of the U.S. tax code (Section 401(k), to be exact). Not the most exciting backstory, but hey, it’s stuck around for a reason.

Types of 401(k) plans

Not all 401(k) plans are created equal. Here’s a quick rundown of the most common types:

• Traditional 401(k): Contributions are made with pre-tax dollars, so you get a tax break now. You’ll pay taxes when you withdraw the money in retirement.

• Roth 401(k): Contributions are made with after-tax dollars, so no tax break now. But your withdrawals in retirement are tax-free, including investment gains. (Also awesome.)

• SIMPLE 401(k): Designed for small businesses, this plan has lower contribution limits and fewer administrative hoops.

• Self-employed 401(k): Perfect for freelancers or business owners, this plan lets you contribute as both the employee and the employer.

How does a 401(k) work? 

Let’s break it down step by step:

1. You decide how much to save: Every pay period, you choose how much of your paycheck to contribute to your 401(k), within the IRS’s annual limit ($23,500 in 2025).

2. Your employer might chip in: A 401(k) match is like free money from your employer. They match a percentage of your contributions, up to a certain limit. Make sure you contribute at least enough to get the full match—it's essentially a guaranteed return on your investment.

3. Your money grows over time: Your contributions are invested in funds chosen by your employer (usually a mix of stocks, bonds, and mutual funds) and managed by the plan administrator (investment company). Over time, your account grows through investment returns and compound interest. The earlier you start, the more your money can grow.

4. You withdraw in retirement: Once you hit age 59½, you can start withdrawing money from your 401(k). With a traditional 401(k), you’ll pay taxes on the withdrawals as ordinary income. However, with a Roth 401(k), qualified withdrawals in retirement are tax-free, because you’ve been taxed on the front end. If you take money out before 59½, you’ll likely face a 10% early withdrawal penalty (with some exceptions, like medical emergencies or buying your first home), regardless of whether it's a traditional or Roth 401(k). 

Read this next: The 4 Steps to Setting up Your 401(k)

What is the difference between a 401(k) and an IRA? 

If you’ve heard about Individual Retirement Accounts (IRAs), you might be wondering how they stack up against a 401(k). Here’s the scoop on IRA vs 401(k):

IRA:

• Opened independently, giving you more control over your investment choices  

• Has lower contribution limits compared to 401(k)s

• Often offers a wider range of investment options, allowing you to diversify your portfolio

• Does not include employer-matching

401(k):

• Offered through your employer, making it a convenient option for many  

• Comes with higher contribution limits, allowing you to save more for retirement  

• May include employer matching, which is essentially free money toward your retirement

2025 contribution limits:

• IRA: $7,000 (or $8,000 if age 50 or older)  

• 401(k): $23,500 (or $30,500 if age 50 or older)

Both IRAs and 401(k) are valuable retirement savings tools. The best option for you depends on your individual circumstances, such as your income, savings goals, and access to an employer-sponsored plan. Plus, you don’t have to choose—many people use both to maximize their retirement savings.

Read this next: 401(k) vs Roth IRA: Which One is Right for You?

How much should you invest in your 401(k)?

As soon as you’ve saved up for an emergency fund, you should contribute to your company’s 401(k). “At the very least, try to defer income up to the company match—and save even more if you can,” says retirement strategist Lena Rizkallah, a financial advisor at Conte Well Advisors. 

Maximizing your contribution is ideal, but sometimes life gets in the way: expenses are high, kids are still in the house, and you’re trying to pay down high-interest debt. “In those cases, try to do as much as you can, and set an auto-escalation feature on your account that will automatically increase your annual contribution every year,” Rizkallah says. “By automating your contributions you don’t have to make the decision to save or how much to put in there.”

We answer your most asked questions on 401(k) plans

Now that we got the basics out of the way, let's do a lightning round answering your questions about 401(k)s. 

1. Is a 401(k) mandatory in the U.S.?

Nope! It’s an optional benefit offered by employers. But if your employer offers one, it’s a no-brainer to take advantage of it.

2. Are 401(k)s good or bad?

Good, with a capital G. They offer tax advantages, potential employer matches, and a structured way to save for retirement. 

While 401(k)s offer substantial benefits, it's essential to be aware of the potential downsides, primarily fees and penalties. 401(k) plans can involve various fees, including administrative fees (covering plan management), investment management fees (charged by mutual fund companies), and sometimes even transaction fees or withdrawal fees. These fees, while often small individually, can erode your savings over time, especially if they're higher than average. 

Additionally, withdrawing money from your 401(k) before retirement age (generally 59½) is usually subject to a 10% early withdrawal penalty on top of the regular income tax you'll owe on the distribution. This penalty, combined with the taxes, can significantly reduce the amount you receive, making early withdrawals a costly decision. Therefore, it's key to understand the fee structure of your specific 401(k) plan and to avoid early withdrawals unless absolutely necessary. 

3. What happens to your 401(k) when you quit?

You’ve got options:

• Leave it in the plan (if allowed). This is an option, but only if your account balance is above a certain threshold (typically $5,000). If your balance is below this amount, your former employer may require you to take a distribution (often called a “cash out”), though they may also allow you to roll it over. Even if you can leave it, it's often not the best choice. You might lose access to certain investment options, and it can be harder to keep track of multiple retirement accounts once you set up a new one at your next job.

• Roll it over into a new employer's 401(k). If your new employer offers a 401(k) plan, you can usually roll over the money from your old 401(k) into the new one. This simplifies things by consolidating your retirement savings into a single account. It also allows you to maintain the tax-deferred status of your savings.

• Roll it over into a traditional or Roth IRA. This is a popular option, especially if your new employer doesn't offer a 401(k) or if you want more investment choices. Rolling over into an IRA gives you access to a wider range of investments than most 401(k) plans. You can roll over a traditional 401(k) into a traditional IRA (tax-deferred) or a Roth 401(k) into a Roth IRA (tax-free growth and withdrawals in retirement).

• Cash it out. This is generally the least desirable option. When you cash out, the distribution is treated as ordinary income and is subject to income tax. Plus, if you're under 59½, you'll also owe a 10% early withdrawal penalty. Cashing out significantly reduces your retirement savings and should be avoided unless absolutely necessary.

4. Does my money grow in a 401(k)?

Absolutely! Your contributions are invested in stocks, bonds, or mutual funds. Over time, they grow through investment returns and compound interest. The earlier you start, the more your money can grow.

5. Can a non-U.S. citizen have a 401(k)?

If you’re a non-U.S. citizen working for an employer in the U.S. that offers a 401(k) plan, you’re generally welcome to join in. However, the tax rules can get a bit tricky depending on your residency status for tax purposes. 

If you’re considered a resident alien, you’ll find that the tax treatment is usually quite similar to what U.S. citizens experience regarding 401(k) plans. On the other hand, if you’re a non-resident alien, there can be some extra complexities, particularly when it comes to withdrawals and what happens when you leave the U.S. 

It’s also worth noting that tax treaties between the U.S. and your home country can play a big role in how you’re taxed. To get into these nuances, it’s a good idea to touch base with a tax advisor who specializes in international tax matters. They can help you stay compliant and make sure you understand your specific tax responsibilities.

6. What is the average 401(k) balance for a 65-year-old?

Different sources provide slightly varying figures, but generally, for 2024, the average 401(k) balance for someone in their 60s (approaching or in early retirement) is somewhere between $200,000 and $300,000. But don’t stress if yours isn’t there yet—everyone’s financial journey is different. These are just averages! Many people have significantly more saved, and many have less.

7. What is a 401(k) withdrawal?

It’s when you take money out of your account. If you withdraw before age 59½, you’ll likely face a 10% penalty and income taxes—unless you qualify for an exception, like unreimbursed medical expenses, tuition expenses, or expenses to repair your primary residence after a casualty (e.g., fire, storm).

8. How does a 401(k) pay out?

When you're ready to start taking money from your 401(k), you'll typically have several payout options:

• Lump-sum distribution: You can withdraw all the money in your 401(k) at once. While this might seem appealing, it can have significant tax implications, as the entire amount is taxed as ordinary income in the year you receive it. This can push you into a higher tax bracket.

• Periodic payments (installments): You can choose to receive regular payments from your 401(k), either monthly, quarterly, or annually. The amount of each payment is usually based on your account balance, life expectancy, and chosen withdrawal schedule.

• Rollover: You can roll over the money from your 401(k) into an IRA. This allows you to maintain the tax-deferred status of your savings and gives you access to a wider range of investment options. You can then take distributions from the IRA according to its rules.

• Annuity: Some 401(k) plans offer the option to use your savings to purchase an annuity. An annuity is a contract with an insurance company that guarantees a stream of income for a specified period, often your lifetime.

• Combination: You can often choose a combination of these options. For example, you might take a lump sum to cover immediate expenses and then set up periodic payments for ongoing income.

The best payout option for you depends on your individual circumstances, including your retirement goals, tax situation, and risk tolerance. It's important to consult with a financial advisor to determine the most appropriate strategy. They can help you understand the tax implications of each option and create a plan that meets your needs.

9. Can I keep my 401(k) if I leave the U.S.?

Yes, you can generally keep your 401(k) even if you leave the U.S. Your options include leaving the funds in your former employer's plan (if allowed), rolling them over into an IRA, or, in some cases, rolling them over into a foreign retirement account (though this is less common and can be complex). 

However, leaving the U.S. can complicate the tax implications of your 401(k). Consider consulting with a tax advisor specializing in international taxation to understand how your 401(k) will be taxed in both the U.S. and your new country of residence. International tax treaties can play a significant role, and failing to understand the rules can lead to unexpected tax liabilities.

10. What happens if you don't want a 401(k)?

If you decide to opt out of your employer's 401(k) plan, keep in mind that you might be missing out on some fantastic benefits, like free money from employer matching contributions and the chance for your savings to grow tax-deferred. 

If opting out feels right for you,  explore other ways to save for retirement. You could look into opening a Traditional or Roth IRA, invest in taxable brokerage accounts, or try different investment options. That said, it’s usually a smart move to at least contribute enough to snag that full employer match—it’s a great way to boost your savings without too much extra effort!

11. How does a 401(k) work when you retire?

When you reach retirement age (generally 59½), you can start taking distributions from your 401(k). You can choose from several distribution options, such as taking a lump sum, receiving regular payments (like an annuity), or a combination of both. With a traditional 401(k), your withdrawals are taxed as ordinary income. 

With a Roth 401(k), qualified withdrawals are tax-free. You can also choose to leave your money in the 401(k) and continue to let it grow tax-deferred (or tax-free with a Roth 401(k)) for as long as you want or are required by law. Required Minimum Distributions (RMDs) typically begin at age 73.

Plan for tomorrow

A 401(k) isn’t just a random number—it’s your ticket to a more secure retirement. Whether you’re just starting out or you’re a seasoned saver, understanding how it works can help you make the most of your financial future.

So, what’s your next move? If you’re not already contributing to a 401(k), now’s the time to start. And if you are, take a moment to review your contributions and make sure you’re on track to meet your goals.

Got more questions? Drop them in the comments below—we’re here to help!