What is a 401(k) and How Does It Work?
A 401(k) is a retirement savings account offered by employers. Money goes in before taxes are taken from your paycheck. That money then grows tax-free until you retire and start taking it out.
Real example: If you earn $75,000 and contribute 10% ($7,500/year), your taxable income drops to $67,500. If you are in the 22% tax bracket, you save $1,650 in taxes this year while still putting away $7,500 for retirement.
The 401(k) Growth Formula
Your 401(k) grows through compound interest. The formula is:
P = annual contribution, r = annual return rate, n = years
Example: Contributing $500/month at 7% annual return for 35 years:
- Your contributions: $500 × 12 × 35 = $210,000
- Final balance: approximately $830,000
- That is $620,000 in growth - nearly 3x your contributions!
2026 401(k) Contribution Limits
| Age | Employee Limit | Total (with employer) |
|---|---|---|
| Under 50 | $24,500 | $70,000 |
| 50-59 or 64+ | $32,500 | $77,500 |
| 60-63 | $35,750 | $81,250 |
The higher 60-63 limit is new from SECURE 2.0 Act, allowing a "super catch-up" for those closest to retirement.
Employer Match: Free Money You Might Be Missing
Many employers will add money to your 401(k) based on how much you contribute. This is called a "match."
Common match example: "50% match up to 6% of salary"
- You earn $80,000 and contribute 6% = $4,800/year
- Your employer adds 50% of that = $2,400/year
- Total going into your account = $7,200/year
That $2,400 employer match is an instant 50% return on your contribution before any investment gains. Not contributing enough to get the full match is like turning down part of your salary.
How Much Should You Contribute?
Minimum goal: Enough to get your full employer match (typically 3-6%).
Recommended: 10-15% of your income including employer match.
Aggressive: Max out the annual limit if you can afford it.
Traditional vs Roth 401(k): Which is Better?
| Traditional 401(k) | Roth 401(k) | |
|---|---|---|
| When you pay taxes | In retirement, when you withdraw | Now, before contributing |
| Benefit now | Lower taxable income today | None (after-tax money) |
| Benefit in retirement | Pay taxes on withdrawals | Tax-free withdrawals |
| Best if you think... | Your tax rate will be lower in retirement | Your tax rate will be higher in retirement |
Not sure? Many financial advisors suggest splitting contributions between both. That gives you flexibility in retirement - you can take traditional withdrawals up to a certain tax bracket, then switch to Roth for tax-free income.
Frequently Asked Questions
What is a 401(k)?
A 401(k) is a retirement savings plan offered through your employer. You contribute money from your paycheck before taxes, it grows tax-free, and you pay taxes only when you withdraw in retirement. Many employers also add matching contributions, which is essentially free money.
What is the 401(k) contribution limit for 2026?
In 2026, you can contribute up to $24,500 if you are under 50. If you are 50 or older, you can add an extra $8,000 "catch-up" for a total of $32,500. Ages 60-63 get a special "super catch-up" allowing $35,750.
How does employer matching work?
Your employer agrees to put money in your 401(k) based on your contributions. A common formula is "50% match up to 6%." If you contribute 6% of a $70,000 salary ($4,200), your employer adds $2,100. Contribute less than 6%, and you leave employer money on the table.
How much should I contribute to my 401(k)?
At minimum, contribute enough to get your full employer match. Beyond that, aim for 10-15% of your income (including the match). If you can max out the contribution limit, even better. Start early - time in the market matters more than timing the market.
When can I take money out of my 401(k)?
You can withdraw penalty-free starting at age 59½. Before that, you typically pay a 10% penalty plus income taxes. Exceptions exist for disability, certain medical expenses, and the "Rule of 55" (if you leave your job at 55 or older). Hardship withdrawals are possible but should be a last resort.
What happens to my 401(k) if I change jobs?
You have four options: (1) Leave it with your old employer, (2) Roll it into your new employer's 401(k), (3) Roll it into a personal IRA, or (4) Cash out. Cashing out triggers taxes plus a 10% penalty if you are under 59½ - avoid this unless absolutely necessary.
Should I choose Traditional or Roth 401(k)?
If you are early in your career with lower income (and lower tax rate), Roth often makes sense - pay taxes now while they are low, enjoy tax-free growth. If you are at peak earning years in a high tax bracket, Traditional lets you defer taxes until retirement when your income may be lower.