What is a 401(k) and How Does It Work?
A 401(k) is a retirement savings plan offered by many American employers, allowing employees to save and invest a portion of their paycheck before taxes are taken out. This powerful savings tool helps you build a nest egg for retirement while also providing tax advantages.
How Does a 401(k) Work?
With a 401(k), a percentage of your paycheck is automatically deducted and invested in various options like stocks, bonds, and mutual funds. The contributions are pre-tax, meaning they reduce your taxable income for the year. The money grows tax-deferred until you start withdrawing it in retirement.
Some employers offer a matching contribution, which means they contribute a certain amount to your 401(k) based on how much you save. For example, if your employer matches 100% of your contributions up to 6% of your salary, you’re essentially getting free money towards your retirement.
Types of 401(k) Plans
There are two main types of 401(k) plans:
Traditional 401(k): Contributions are made with pre-tax dollars, lowering your taxable income. You pay taxes when you withdraw the money in retirement.
Roth 401(k): Contributions are made with after-tax dollars, meaning you won’t get a tax break upfront. However, withdrawals during retirement are tax-free, including any investment gains.
Contribution Limits
The IRS sets annual contribution limits for 401(k) plans. For 2025, the contribution limit is $23,500 for those under 50. If you’re 50 or older, you can contribute an additional $7,500 as a catch-up contribution, totaling $30,000. To learn more about contribution limits to a 401k in 2025, read this IRS article.
When Can You Withdraw from a 401(k)?
You can start taking penalty-free withdrawals from your 401(k) at age 59½. If you withdraw earlier, you’ll face a 10% penalty plus income taxes unless you qualify for certain exceptions, such as disability or substantial medical expenses.
By age 73, Required Minimum Distributions (RMDs) must begin, meaning you’re obligated to withdraw a minimum amount each year.
Benefits of a 401(k)
Tax Advantages: Contributions reduce taxable income (Traditional) or allow tax-free withdrawals (Roth).
Employer Match: Free money added to your retirement savings.
Compound Growth: Earnings grow tax-deferred, accelerating wealth accumulation.
Automatic Savings: Contributions are automatically deducted, making it easier to save consistently.
Potential Drawbacks
Limited Investment Choices: Usually restricted to the options provided by your employer.
Early Withdrawal Penalties: A 10% penalty for early withdrawals before age 59½.
Required Minimum Distributions: Mandatory withdrawals at age 73 for Traditional 401(k)s.
Should You Contribute to a 401(k)?
Contributing to a 401(k) is generally a smart financial move, especially if your employer offers a matching contribution. However, it’s essential to assess your financial situation, risk tolerance, and retirement goals before deciding how much to contribute.
Need a Retirement Plan Review?
If you need help with reviewing your retirement accounts, give our financial advisors a call. We offer free financial consultations. Contact us here to schedule an appointment.
Disclosure
IntelliVest Wealth Management is a Registered Investment Advisor Headquartered in Spartanburg South Carolina. This is not a solicitation or financial advice. Please note that this information may not be accurate as changes to laws and regulations change from day to day. This article should only be used for educational purposes. Please consult with IntelliVest Wealth Management about your personal financial situation.
