A complete guide to 401(k) retirement plans: What is a 401(k)?

If you’re working and already saving for retirement or plan to start socking away money soon, investing in a 401(k) plan can help you build a sizable nest egg.

If you’re thinking about signing up for a 401(k), or simply want to know more about how to take full advantage of this type of retirement plan, here’s everything you need to know.

What is a 401(k) plan and how does it work?

A 401(k) plan is a tax-advantaged retirement savings tool offered by employers that allows eligible employees to contribute a portion of their salary up to a set amount each year.

Unlike traditional pension plans, in which the employer promises a specified monthly benefit at retirement, 401(k) plans are funded by contributions deducted directly from the employee’s paycheck. Many companies match contributions up to a certain percentage of your annual salary.

Getting started with a 401(k)

While 401(k) plans are broadly similar, each employer’s plan can differ in important ways, such as whether you can take a loan against your savings or the types of investments available. Here are some key things to understand about your plan as you get started:

• What are your company’s eligibility requirements and will you automatically be enrolled in the plan?
• Will the plan automatically increase your contribution each year?
• Does your company offer a matching contribution and how much is it?
• What investment options does the plan offer? What do they cost and are those funds expensive relative to other available options?
• Does the plan offer any third-party advice (such as from the plan’s administrator) or any option to have the account managed for you?
• Can you invest in individual securities or do you have to stick to the funds provided in the plan?
• Can you take a loan against your account balance? How much does the loan cost?

These are a few of the most important questions that you’ll want to answer as you get started with your 401(k). Don’t assume that all plans are alike, because your employer may change important aspects of the plan — even beyond the basics, such as its matching contribution.

How much should you contribute to your 401(k)?

When it comes to how much of your pay you should contribute, everyone has different financial needs in retirement, but there are some general rules you can follow.

Contribute enough to take advantage of any matching dollars offered by your employer, says Catherine Golladay, former managing director at Charles Schwab.

Whether your company match is dollar-for-dollar or something smaller, such as 50 cents on the dollar, don’t pass up the match. “Not doing so is like leaving money on the table,” she says.

After saving enough to get the full employer match, Golladay suggests paying off high-interest debt and building an emergency fund. Then, go back and maximize tax-advantaged retirement accounts, either the 401(k) or retirement accounts, such as an individual retirement account (IRA) or Roth IRA.

About 70 million Americans invest in 401(k)s and these retirement plans hold $8.9 trillion in assets, according to the Investment Company Institute, citing data as of Sept. 30, 2024. Plan participants can roll up substantial savings over the years of their working lives. Here’s how much the average American has in a 401(k) by age.

Bankrate’s calculator can help you decide which tax-advantaged account to stash additional funds in.

Contribution limits for 401(k) plans

In 2025, the IRS lets you contribute up to $23,500 to your 401(k). If you’re age 50 or older, you can add a $7,500 catch-up contribution. Employer matching doesn’t count toward this limit, so the total can be even higher.

These limits typically go up every year to keep pace with inflation, so check annually to see if you can stash away more money.

How employer matching works

Employer matching is one of the biggest perks of a 401(k). If it’s offered at your job, your employer agrees to match a portion of your contributions. For example, they might match 100 percent of your contributions up to 4 percent of your salary.

Some employers use a partial match — 50 percent of your contributions up to 6 percent of your salary, for example.

But there’s a catch. You may need to stay with the company for a few years to fully “own” the match. This is called vesting. Some employers vest you immediately, while others make you wait a year or longer.

As Golladay notes, getting that company match is essentially free money. Always contribute at least enough to get the full match, even if you can’t max out your account.

Investing options for 401(k)s

Most 401(k) plans have at least three investment choices, though others offer many more options. The average plan offers about 28 investment options, according to the Investment Company Institute.

The menu could include a mix of investments, such as mutual funds, company stock and index funds, as well as stable value funds (or cash), bond funds and so-called “target date” funds, which adjust your portfolio based on your years until retirement.

Fortunately, while you can pick your own funds if you’re the do-it-yourself type, you often don’t have to decide how to invest completely on your own.

“Many of today’s 401(k) plans include professional investment advice, which can be key in helping the participant make investment decisions based on their overall financial picture,” Golladay says.

Target-date funds (TDFs) have become popular options because they automatically adjust the mix of investments over time to align with investors’ risk tolerance as they approach retirement. For example, they move money from higher-risk stock funds to lower-risk bond funds as you near retirement, so that you have a more stable portfolio when you need the money.

While target-date funds meet many investors’ demands, they don’t fit every individual’s needs.

“While a TDF can be effective, a more tailored portfolio based on multiple data points about the investor may be the best option for some,” Golladay says.

Here are other ways that you can maximize your 401(k) over time and generate higher returns.

How to choose investments for your 401(k)

Here are some smart moves to make with your 401(k), including how to earn a higher return by being aggressive with your investments and when not to:

• Design your investments with your age in mind. Avoid being too conservative when you’re younger and too aggressive when you’re old. If you’re in your 20s or 30s, you can afford to be more aggressive with your investments — investing more or all of your money into potentially higher-returning stocks or stock funds — because you have more time to recover from any market slumps along the way. As you age, however, your asset allocation should shift to more conservative investments — bonds or bond funds — to help protect your portfolio from the volatility of stocks.
• Index funds, such as those based on the S&P 500 index, are a good all-around pick for the stock portion of your portfolio. They’re a top recommendation from legendary investor Warren Buffett.
• Use any tools offered by your 401(k) provider. Many 401(k) plans offer tools (online calculators, worksheets) for determining risk tolerance and suitable investment options.
• If you’re not comfortable selecting funds or building an investment portfolio on your own, the best tool may be a competent financial advisor. Select an advisor who can design a long-term plan for you and help you stick to it — here’s how to find one.
• Time is your most important ally when investing for retirement. It’s less important to find the very best investment than it is to find a good investment and then buy and hold it for years, if not decades.

Before you can decide how to allocate your contributions, determine your risk tolerance. It’s critical to know how well you can deal with volatility in your portfolio. You want to make sure you can sleep at night if financial markets turn turbulent and asset prices fall. But keep in mind that markets historically have recovered even after brutal bear markets, or stock market declines of 20 percent or more, which are typical during recessions.

Bankrate’s 401(K) calculator can help you estimate your savings over time.

Why should you invest in a 401(k)?

A 401(k) is an excellent investment option, and everyone should consider opening an account if they’re able to. Not all employers offer a 401(k) retirement plan, but if yours does, it’s a smart move to participate in one for the following reasons:

Still, some investors are worried about investing in stocks because of their riskiness.

“All investments come with risk, but the fear of losing money should not inhibit someone from utilizing a 401(k),” Golladay says.

While markets go up and go down, history has shown that over the long run, they move up. As measured by the S&P 500 index, over time stocks returned around 10 percent annually. The S&P 500 comprises hundreds of America’s largest publicly traded companies.

That’s why investors, especially the risk-averse, should take a long-term approach to their retirement investments.

“In times of market volatility or uncertainty, it’s important to remember that panic isn’t a strategy, especially with an investment as long-term in nature as a 401(k),” Golladay says.

401(k) loans: What they are and how they work

If you need cash for an emergency or to pay down debt, your 401(k) plan may allow you to take out a loan and borrow up to 50 percent of your vested balance, but not more than $50,000.

In most cases, you have to repay the money with interest within five years. While the interest payments go into your account — which means you are paying yourself back rather than giving your money to a bank — there are significant downsides.

When you make a 401(k) withdrawal, that money is no longer invested in the market, and therefore, you could miss out on gains if asset prices continue to rise. Also, the original contributions to the account were made with pre-tax dollars, but the loan payments will be made with after-tax dollars. So, you’re losing a key tax benefit here.

If you leave your employer, you’ll also have to repay your loan faster, generally when taxes are due for the current tax year.

Try to avoid taking a 401(k) loan if at all possible, though it may be better than taking an early withdrawal.

401(k) FAQs

• What’s the difference between a traditional 401(k) and a Roth 401(k)?

  The 401(k) has two varieties: the traditional 401(k) and the Roth 401(k).

  • Traditional 401(k): Employee contributions are made with pre-tax dollars, lowering your taxable income now. Your contributions grow tax-deferred until withdrawn, meaning all of your money is working for you in the market.
  • Roth 401(k): Contributions are made with after-tax dollars, meaning you don’t get a tax benefit today. Your contributions grow tax-free until withdrawn in retirement and then you’ll be able to avoid tax entirely on the distributions.

• What happens to your 401(k) when you switch jobs?

  Fortunately, a 401(k) offers portability, so you don’t need to be stuck in a former plan if you don’t like it. Workers have a few options for dealing with their old 401(k) after leaving a company:

  • Roll it over into an IRA.
  • Keep the assets in the former employer’s plan, if permitted.
  • Roll it over into a new employer’s plan, if permitted. You may also have the option of taking a cash distribution, or lump sum, but you’ll probably get hit with penalties and taxes if you’re not at least of retirement age.

  Whichever path you choose, it’s important to understand the benefits and limitations of each option according to your unique financial situation, Golladay says.

• What is the early withdrawal rule for a 401(k)?

  Taking money out of your 401(k) before age 59½ is expensive. You’ll owe income tax and a 10 percent IRS penalty unless you qualify for an exception.

  Exceptions include disability, certain medical bills, a first-time home purchase or separation from your job after age 55. But even with an exception, you’re robbing your future self.

  Taking an early distribution could be disastrous for your retirement, and more than half of Americans say they are behind in saving for retirement, according to a Bankrate survey.

  Unless you’re in a serious emergency and have no other options, leave your 401(k) alone until retirement.

• Can you lose money in a 401(k)?

  The short answer is yes. The longer answer is that whether you make money or lose money in a 401(k) depends on your investments. Some investments, such as U.S. government bonds, may have explicit promises to be repaid, or you may have an investment in cash, which will not decline in value, though it will lose purchasing power over time due to inflation.

  Other market-based investments, including government bonds, are subject to fluctuations in value, so you may not receive back what you put into the investment. For example, while holders of government bonds will receive their principal back at maturity, the bonds may fluctuate a lot in the interim. So if you have to sell the bond before it matures, you may not receive the price you paid for it. At maturity, you will receive full value, however.

  Assets such as stocks can fluctuate a lot more in the short term than bonds. That’s why financial advisors recommend having a longer time horizon for stocks. You’ll need to ride out the market’s ups and downs in order to achieve stocks’ potentially more attractive long-term returns.

  However, regardless of your investment choices, you’ll still pay fees for any funds that you’re invested in. Your long-term performance depends on those fees, so it’s important to minimize them where you can. And don’t think that a higher-priced fund is necessarily better than a low-cost fund. Often higher-priced funds have lower long-term returns than the lower-fee funds.

• What are required minimum distributions (RMDs)?

  Starting at age 73, you’re required to start taking money out of your traditional 401(k). These are called required minimum distributions, or RMDs.

  The IRS forces you to withdraw a certain amount each year so it can finally collect taxes on your tax-deferred savings. If you skip or shortchange your RMD, the penalty is steep: up to 25 percent of what you should have withdrawn.

  It’s important to know your RMD schedule, calculate the right amount to withdraw and plan ahead because the IRS won’t remind you.

— Bankrate’s Rachel Christian contributed to an update.