Benefits of a 401(k)

If your employer offers a 401(k) plan, you have a golden opportunity. Contributing to a 401(k) is one of the best ways to save money for a comfortable retirement.

A 401(k) account:

• reduces your taxable income. You don’t pay taxes on your 401(k) earnings until retirement, when you withdraw the funds. And by then, you may be in a lower tax bracket.¹
• makes saving easy. Contributions go directly from your paycheck into your 401(k) account. You never see the money, so you won’t spend it.
• may provide “free money.” A 401(k) is usually an employer-sponsored retirement plan, and some employers contribute funds to the employee’s 401(k).
• offers higher contribution limits than an IRA. In 2026, you can contribute up to $24,500 a year to a 401(k) plan, compared to just $7,500 for an IRA, another popular retirement savings plan. This can help you grow your retirement savings more quickly.
• protects your money from certain debts. The Employee Retirement Income Security Act (ERISA) protects your 401(k) funds from bankruptcy and civil lawsuits. (It does not, however, protect it from criminal fines, certain domestic relations orders, or federal tax liens.)

What is a 401(k)?

A 401(k) is a voluntary, tax-advantaged retirement savings plan. It’s usually offered by an employer as part of a job benefits package, like healthcare or paid vacation time.

As an employee, you contribute a portion of each paycheck — a percentage you choose — to the 401(k). That money gets deposited directly into your 401(k) account, so you don’t even need to think about it.

Those funds are then invested, so your money can grow. You can choose from various investment options such as mutual funds, exchange-traded funds (ETFs), index funds, and such. If you’re lucky, your employer will even match your 401(k) contributions to help boost your retirement savings

Your savings grow in your 401(k) account, untouched, until you reach the retirement age of 59½, the earliest you can withdraw money without paying a 10% early withdrawal penalty. In certain circumstances, however, you can withdraw early without paying a penalty.

You can withdraw 401(k) funds penalty-free if:

• you qualify for the Rule of 55, which kicks in if you leave your employer or are fired during the year you turn 55 or after.
• you have an “immediate and heavy financial need” such as medical costs.

Tax benefits of a 401(k)

There are two main types of 401(k) plans — a traditional 401(k) and a Roth 401(k). The primary difference is in how they’re taxed.

With a traditional 401(k):

• you get an immediate tax break. Your contribution is taken out of your paycheck before taxes, reducing your taxable income for the year. Let’s say you make $65,000 this year and contribute 4 percent of your income ($2,600) to your 401(k) during the year. Come tax time, you’ll pay taxes on your annual income ($65,000) minus your contribution ($2,600), which is $62,400. If you hadn’t contributed to a 401(k), you would have paid taxes on your entire income of $65,000.
• your investments grow tax-free. At tax time, you don’t pay tax on any interest, dividends, or capital gains.
• you pay income tax when you withdraw funds, usually in retirement. You essentially pay income tax on the amount you withdrew during the year.

With a Roth 401(k):

• you pay income tax now, while you’re working. Any contributions that you make to your Roth 401(k) are counted as taxable income for the year.
• the money in your 401(k) account grows tax-free. As with a traditional 401(k), you don’t pay annual taxes on interest, dividends, or capital gains.
• you enjoy tax-free withdrawals in retirement. When you retire, you can withdraw contributions and investment returns tax-free, as long as you’re at least 59½ years old and have had the Roth 401(k) for five years.

Tax-deferred vs. tax-exempt retirement savings

With most investment accounts, you must pay tax on any dividends and gains. But there can be differences in when you pay.

A traditional 401(k) is a tax-deferred account, meaning you postpone paying taxes until retirement. During your working years, the funds — your contributions, interest, dividends, capital gains — grow tax-free. So, if you’re in a higher tax bracket now, a traditional 401(k) may work to your benefit. Later, when you retire and begin making withdrawals, Uncle Sam will treat those withdrawals as taxable income. Some states also tax 401(k) withdrawals. In California, for example, money withdrawn from a 401(k) is taxed as regular income, and you’ll pay an additional 2.5% on withdrawals taken before age 59½.

If you have a Roth 401(k), you pay taxes now, but your funds will be tax-exempt at withdrawal. You make contributions while you’re working and pay taxes for the year you make those contributions. You get your tax break in retirement, when you’re able to make withdrawals without paying income tax on them.

Match Game

Companies contribute an average of 4.6% of the employees’ salary to their 401(k) plan, according to Vanguard’s 2025 report, How America Saves.

Employer matching

Some employers will match an employee’s 401(k) contributions, which can help supercharge your retirement savings. Your employer, for example, might contribute $0.50 for every $1 that you contribute, up to a maximum amount.

If your employer offers a 401(k) with a matching contribution, accepting that benefit is a smart move. Otherwise, you’re walking away from free money.

Borrow against a 401(k)

Some 401(k) plans allow you to borrow from your account balance. You may decide to use a 401(k) loan to pay off high-interest debt, for example. You can typically borrow up to 50 percent of your vested account balance or $50,000, whichever is less, but make sure you understand the limits and rules of your own 401(k). And keep in mind that some 401(k) plans only allow you to take out a loan for specific purposes.

You do need to pay interest on the loan. A 401(k) loan isn’t usually taxable, although there are exceptions. If you don’t repay the loan on time, you may pay taxes on it. Also, if you leave your employer, you’ll need to repay the loan within a certain time period. But check the provisions of your 401(k) for details.

Your 401(k) is yours — even if you change jobs

If you leave a company, you have some options regarding your 401(k).

You can leave your 401(k) account with your employer, as long as you’ve invested at least $7,000. If you like the investment options, this might be a smart move. Your retirement savings will continue to grow, although you’ll no longer be able to contribute to it. So, if you choose this option, make sure to sign up for your new employer’s retirement plan.

You may prefer to move the funds to your new employer’s 401(k), if your new company offers a 401(k) and it allows rollovers. The administrator of your existing plan may be able to make a direct transfer, or you may receive a check in the amount of your 401(k)’s balance. If you receive a check, make sure to deposit those funds into your new 401(k) to avoid paying taxes.

If your new employer doesn’t offer a 401(k), you can open an IRA yourself and roll over the funds into that IRA. Your IRA’s sponsor or a financial advisor can guide you through the process. If you have less than $7,000 in your 401(k) account, your old employer may move the funds into an IRA for you.

Another possibility is to cash out. If you choose this option, your old employer will send you a check. You’ll be reducing your retirement savings, however, and you’ll pay tax on the full amount. It’s best to keep those funds in some sort of investment account, so you can stay on track with your retirement savings goals. Keep in mind that there’s a 10% federal penalty if you withdraw funds before age 59½.

401(k) limitations

When opening a 401(k) account, make sure you understand the rules.

401(k) contribution limits

The federal government sets a 401(k) contribution limit. So, at the start of each year, check with the IRS to make sure you know the limit. In 2026, the annual 401(k) contribution limit is $24,500. If you will be at least 50 years old by December 31 of the year, you can add a “catch-up” contribution of $8,000, to boost your retirement savings. So in 2026, the contribution limit for workers age 50 and up is $32,500. Employees who are 60, 61, 62, or 63 can add a “super catch-up” contribution of up to $11,250 in 2026. That means the contribution limit for workers age 60 to 63 is $35,750.

401(k) vesting

Vesting refers to gaining ownership of your 401(k) balance. As an employee, any funds that you contribute to your 401(k) are fully vested. That means you own those dollars outright.

If your employer makes contributions to your 401(k), however, those funds may be subject to a vesting period. Let’s say that your 401(k) has a two-year vesting period. That money won’t really be yours until you’ve held your job for two years. If you leave the job after one year, you’ll be able to keep any funds that you contributed to your 401(k), but none of the funds that your company contributed. If you stay for two years, though, the entire balance — your contributions and your employer’s — belongs to you.

Early withdrawal penalties

You can begin making withdrawals from your 401(k) at age 59½. If you withdraw funds earlier, you will pay a 10% tax penalty, wiping out the full tax advantages that normally come with a 401(k).