How 401(k) Plans Work: Company Matches, Tax Rules and More

Of the different kinds of employer-sponsored retirement savings plans, 401(k) plans are the most common. Indeed, more than half of Americans actively participate in retirement plans such as 401(k)s. Thanks to the SECURE Act, which was signed into law at the end of 2019, retirement planning has become even more widespread. The act requires companies that offer 401(k) plans to extend the benefit to part-time workers (who work 500 hours per year for three consecutive years). This is how 401(k) plans work and how you can get the most out of your retirement savings account.

A financial advisor can help you create a financial plan to reach your retirement goals.

What Is a 401(k) Plan?

A 401(k) plan is a workplace retirement savings program sponsored by a private employer. It is offered to employees as part of their general benefits package, alongside perks like vacation days and healthcare coverage.

While there is no law requiring workplaces to offer a retirement savings plan to employees, there are laws governing how 401(k)s are administered. The primary law is the Employee Retirement Income Security Act (ERISA) of 1974.

Companies create 401(k) plans with financial service providers. The plan offers an array of investment options, often mutual funds, although the SECURE Act adds the option of annuities.

Eligible employees can decide if they want to participate, as the plan is completely voluntary. However, you may have to opt out if your company automatically enrolls you. If you do want to participate, your contribution amount, typically a percentage of your pay, is up to you. Keep in mind that your employer may have an automatic default percentage that you will have to change if it is too high or low.) Still, it’s your call how you invest your money.

Another benefit some companies offer to employees is an employer match. This means the company will match a percentage of the money employees contribute to their 401(k) account. This could be a straight 401(k) match, which is when a company offers a full match up to a certain percentage of an employee’s annual income. More commonly, it’s a partial match, where a company matches a percentage of an employee’s contributions, up to a cap.

The maximum amount you can contribute to a 401(k) plan has been steadily rising. In 2026, the maximum contribution is $24,500, with catch-up contributions of $8,000 for those 50 and older and a super catch-up contribution of $11,250 for those ages 60 to 63.

This is an increase from 2025, the maximum contribution is $23,500, plus catch-up contributions of $7,500 for those over 50. In 2024, the limit was $23,000 with an additional $7,500 for those over 50.

Taxes and 401(k) Plans

Tax treatment is what makes 401(k) plans so attractive.

Dollars you put in the plan do not count toward your taxable income. You don’t pay taxes on them until you retire and start making withdrawals. (There are newer Roth 401(k) plans, where you pay taxes on your contribution – and your withdrawals are completely tax-free, including earnings.)

The appeal of deferring taxes is that you will likely be in a lower tax bracket when you retire. Also, some states exempt or partially exempt money withdrawn from retirement accounts from the state income tax.

That said, if you are at the beginning of your career or working part-time, you may not want to defer taxes. After all, you’re probably now in a lower tax bracket than you will be in retirement. If that’s the case, you should contribute to a Roth 401(k) if it’s available.

If it’s not an option, though, you should then contribute to the traditional 401(k) – especially if your employer offers a match. Not taking the match is like leaving money on the table.

401(k) Plan Investments

Typically, 401(k) plans offer several types of assets, including mutual funds, exchange-traded funds (ETFs), individual stocks and bonds, as investment options. If your employer is a publicly traded company, you may be able to buy company shares in the plan, with annuities joining the menu.

Mutual funds and ETFs, which invest in a number of different securities, are the predominant investment options in 401(k) plans. That’s because the risk is diluted among the different securities – and possibly different sectors. When a fund is passively managed, it tracks a certain stock index and generally fluctuates in line with the market.

401(k) Withdrawal Rules

You can’t withdraw money from a 401(k) plan until you turn 59.5. Any early withdrawals you make before then are subject to ordinary income taxes and a 10% penalty.

There are some exceptions, however. These include death, disability or a qualified domestic relations order following a divorce.

If you really must take money out of your 401(k) before retirement age, some companies will allow you to borrow from your 401(k). You pay back the money over a period of time at a low interest rate.

The biggest risk here is that if you lose your job and are no longer part of the plan, you must pay back the loan within 60 days. If you don’t pay it back in full, the loan is treated as an early withdrawal.

How to Open a 401(k) Plan

To participate in a 401(k) plan, you must be employed by a company that offers one. Check with your human resources department to confirm whether your employer provides this benefit and to obtain enrollment details.

Once you have the necessary information, you can set up a 401(k) account. During the setup process, provide basic details such as your Social Security number. After your account is established, you’ll decide what percentage of your paycheck to contribute and then select investment options for your funds.

Additionally, you’ll designate a beneficiary, typically a spouse or a close family member, who will inherit the account in the event of your passing.

Vesting Rules and What Happens When You Change Jobs

One feature of many 401(k) plans that often gets overlooked is vesting. This determines how much of your employer’s contributions you actually own if you leave the company.

Your own contributions are always fully vested, but employer matches may follow a schedule. Some plans use cliff vesting, where employer contributions become yours all at once after a set number of years. Others use graded vesting, which transfers ownership gradually over time. If you leave before you are fully vested, the unvested portion of the employer match is forfeited.

Switching jobs also raises questions about what to do with your existing 401(k). When employment ends, the account does not disappear, but active contributions usually stop. The balance can remain in the former employer’s plan, subject to the plan’s rules and investment menu. This option may appeal to workers who are satisfied with the plan’s investment options and administrative structure.

Another common solution is to move the balance into a new employer’s 401(k) if the new plan accepts rollovers. This can consolidate retirement savings in one place and make ongoing contributions easier to track. A third option is rolling the balance into an individual retirement account, which may offer a wider range of investment choices and more control over withdrawals later on.

Each of these outcomes carries different administrative rules, investment flexibility and tax reporting requirements. Vesting status, account size and access to future employer plans all play a role in determining how a 401(k) fits into a longer-term retirement strategy when employment changes.

Bottom Line

A 401(k) plan is a common way to save for retirement. Employers sponsor 401(k) plans, and employees invest pre-tax money. Investment options include stocks and bonds, but most people choose less risky options like mutual funds and ETFs, which are inherently diversified. Some companies may even offer an employer match, free money based on how much you save.

Retirement Tips

A financial advisor can help you figure out how to maximize your 401(k) savings. SmartAsset’s free tool connects you with vetted financial advisors who serve your area in five minutes. If you’re ready to be matched with local advisors, get started now.
Do your research to make sure you’re making the best retirement choice for your needs. Here’s a breakdown of IRAs vs. 401(k)s.
Don’t forget that you’ll get a Social Security check from the government in addition to your own retirement savings. See how big of a payment you can expect using SmartAsset’s free Social Security calculator.