What is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that lets you invest a portion of your paycheck before taxes are taken out. Your contributions reduce your taxable income today, and your investments grow tax-deferred until you withdraw them in retirement. Many employers also match a portion of your contributions — which is essentially free money.
Key 401(k) Rules
- Contribution limit — $23,000 per year (2024). If you are 50 or older, an additional $7,500 catch-up contribution is allowed ($30,500 total)
- Tax benefit — Traditional 401(k) contributions are pre-tax. If you earn $80,000 and contribute $10,000, you are only taxed on $70,000. This saves you $2,200 in taxes (at 22% bracket) immediately
- Roth 401(k) — Some employers offer Roth 401(k) option. Contributions are after-tax, but withdrawals in retirement are completely tax-free. Best if you expect to be in a higher tax bracket in retirement
- Employer match — Common formulas: 50% match up to 6% of salary, or 100% match up to 3%. On a $80,000 salary with 50% match up to 6%: you contribute $4,800, employer adds $2,400. That is an instant 50% return
- Vesting — Your contributions are always 100% yours. Employer match may vest over 3-6 years. Check your vesting schedule before changing jobs
- Withdrawals — Generally cannot withdraw before age 59½ without a 10% penalty + income tax. Some hardship withdrawals and loans are allowed
How to Maximize Your 401(k)
- Step 1: Get the full match — Contribute at least enough to get 100% of the employer match. Not doing this is giving up free money. This is the minimum you should do
- Step 2: Choose the right investments — Pick low-cost index funds if available. Target-date funds are a great one-fund solution. Avoid high-fee actively managed funds
- Step 3: Increase contributions annually — Increase by 1-2% each year, especially after raises. Most people do not notice the difference in their paycheck
- Step 4: Do not touch it — Resist the temptation to take loans or early withdrawals. A $10,000 withdrawal at age 30 costs you $170,000+ in lost growth by age 65
- Step 5: Roll over when changing jobs — Roll your 401(k) into your new employer plan or into an IRA. Never cash it out — you will pay taxes plus 10% penalty, losing up to 40% immediately