Understanding Your 401(k): A Comprehensive Guide to Retirement Savings

There are a lot of reasons why it’s important to plan for financial security in retirement, but one of the main goals is to build enough wealth that you have plenty of money to truly enjoy your golden years.

Wealth planning for retirement not only helps improve your financial stability during your senior years, but it also can greatly improve your quality of life by alleviating stress caused by unexpected financial burdens or costly end-of-life care.

Millions of Americans have built retirement wealth using employer-sponsored 401(k) savings plans. At the end of 2023, these plans held more than $7.4 trillion in assets. Follow this step-by-step guide to set up and maximize your 401(k) contributions and build your own nest egg for retirement.

The 401(k): Your Ultimate Tool for Building Retirement Wealth

More than 70 million Americans have active employer-sponsored 401(k) plans, making it by far the most popular direct-contribution retirement plan. A 401(k) is a type of workplace retirement plan offered by employers to help employees save for retirement. Here’s how employer-sponsored savings plans work.

What is a 401(k)?

There are two types of employer-sponsored 401(k) direct-contribution savings plans: traditional and Roth. Traditional 401(k) have been around since the late 1970s. Roth 401(k)s, meanwhile, first became available at the start of 2006.

There’s one big difference between the two plans. With a traditional 401(k), you make contributions on a pre-tax basis, meaning you put in money earned at your job before taxes are taken out. The money amassed in your 401(k) is taxed when you begin taking withdrawals during retirement.

With a Roth 401(k), contributions are made as after-tax contributions from income that’s already been taxed, so you don’t have to pay any additional taxes when you begin taking distributions, regardless of how much your 401(k) balance has grown over the years. After-tax contributions differ from pre-tax contributions in that taxes are paid upfront rather than at withdrawal.

Key benefits of a 401(k)

Employer-sponsored retirement plans offer a range of benefits.

• Employer contributions. Many employers have programs in place where they match employee contributions to 401(k) savings plans. A common match formula is a dollar-for-dollar match for up to 3% of your gross salary, then a $.50 match for another 2%.
• Compounded growth. The power of compounded growth can’t be overstated – it’s the true superpower of your 401(k). Investment gains within your 401(k) are tax-deferred in a traditional plan or tax-free in a Roth plan, allowing your money to grow faster over time.
• Tax-deferred contributions, tax-free earnings, and tax break. Putting tax-deferred contributions into a traditional 401(k) lowers the amount of taxable income you have to report on your annual tax return, providing a valuable tax break. With a Roth 401(k), your post-tax contributions mean tax-free earnings on your plan’s growth.

Your 401(k) Starter Guide: 3 Easy Steps to Kick Off Your Retirement Savings

You don’t have to be a financial guru to kick off your 401(k) and start putting aside money for your senior years. Eligible employees—those who meet the plan’s participation criteria—can take advantage of these retirement savings opportunities. Follow these 3 easy steps below to begin your retirement savings.

Step 1. Confirm Eligibility

Making contributions to employer-sponsored 401(k) plans usually comes up after accepting a job offer or after a predetermined time, such as passing 30 days on the job for new hires.

The Internal Revenue Service states in its 401(k) eligibility requirements that employees must be at least 21 years of age and complete a minimum of one year of workplace service to be eligible for enrollment. Employers are free to set their own 401(k) eligibility requirements. However, a one-year service commitment is a common eligibility term. The plan sponsor, typically the employer, is responsible for establishing these eligibility rules. Part-time employees, meanwhile, may be eligible to enroll in a 401(k) plan after three consecutive years of employment or 500 hours worked in a calendar year.

Make sure to check with your employer about their 401(k) eligibility requirements since they can vary greatly between companies.

Step 2. Review Plan Details

Eligibility isn’t the only issue that needs to be sorted out before you enroll in a 401(k).

Many employers offer company managed 401(k) plans, which are a type of defined contribution plan. This removes the burden of making important investment decisions from employees. However, more and more companies are offering plans that allow employees to direct their own investments (usually from a fairly limited pool of choices). Self-managed plans allow employees to steer their contributions into investments that align with their personal philosophies or tolerance for risk, as well as to maximize returns through regular rebalancing of investments.

Employers also may match your 401(k) contributions, often providing matching funds. Matching funds are employer contributions made on your behalf, typically based on a percentage of your own contributions. It’s common to match on a dollar-for-dollar basis up to 3% of an employee’s gross annual salary, and 50% match for an additional 2%. Match formulas vary, however, so be sure to understand what your employer is willing to contribute so you can maximize your annual contributions. Similarly, be sure you know what your available investment options are as well.

Step 3. Enroll

The new year brought about an exciting change for employees who want to participate in their company’s retirement plans. Starting in 2025, eligible new employees are automatically enrolled in 401(k) plans unless they already have a retirement plan in place, and existing employees are automatically enrolled as well.

These new provisions are part of the Secure 2.0 Act. In the past, employees had to complete paperwork provided by their company’s human resources department or hiring manager. Now, employees in most instances will be auto-enrolled, though you may still have to complete some paperwork or online documents to direct your investment choices and denote the amount of your pre-tax contributions.

When enrolling, the employee contributes to the plan by selecting how much of their salary to defer, which can include pre-tax, Roth, or catch-up contributions depending on eligibility and plan options.

During enrollment, you may have to choose between a traditional or Roth 401(k) if that’s an option at your workplace. Getting enrolled is the easy part – choosing your investments may prove to be a bit more challenging.

Be sure to review plan fees associated with your investment options, as these can impact your overall retirement plan.

Building Your Financial Future: How to Pick the Right Investments for Your 401(k)

There are multiple factors to consider before allocating funds to the different types of investments available to you through your company’s 401(k) plan. Age, investment timeline (also called investment horizon), your appetite for risk, available investment options and how much money you need during retirement are among the most important considerations to picking the right investments for your 401(k).

For example, target-date funds automatically adjust their investment mix based on your planned retirement date, helping to align risk and simplify your investment decisions as you approach retirement.

Types of investment options

Retirement plans usually offer a mix of stocks, bonds and mutual/target-date funds.

• Stocks. 401(k) plans don’t usually let participants invest in individual company stock. Instead, options are often restricted to large-capitalization stock funds that are a pool of companies with a certain minimum market-capitalization threshold, such as $10 million or $20 million.
• Bonds. Bond funds, like stock funds, are a pool of bonds that may include corporate, government, municipal and short-, medium-, and long-term bond funds.
• Mutual funds. Mutual funds are a pool of different stocks and bonds. Investing in these professionally managed funds comes with a fee, but you can lean on the expertise of financial professionals. Mutual funds are typically offered by a financial institution, which manages the investments on behalf of plan participants.
• Target-date funds. Target-date funds are designed for long-term savers. You invest in the fund, and your contributions are allocated according to your investment horizon. Early on, asset allocation will be more aggressive, and as you approach retirement, allocation shifts to minimize risk of losses.

Risk tolerance

Risk tolerance, also referred to as your appetite for risk, is an extremely important consideration in asset allocation. Some investments, like stocks, pose much greater risk of loss than others, such as government-backed bonds and securities. Greater risk can lead to increased returns, as well as larger losses in the event of a market downturn. 

Risk tolerance, like investment horizon below, is unique to each individual investor or retirement saver.

Investment horizon

When you are young, you have a much longer investment horizon since you’ll be working for several more decades. You can afford to be more aggressive with your investment dollars because you have time to recover from downward market swings.

When you are older and closer to retirement, though, you’ll want to take on less risk since your investment timeline is much shorter.

Matching investments to retirement goals

Once you’ve gotten your 401(k) investments dialed in, you can’t just forget about them. You’ll want to pay attention to two important aspects of investment and portfolio management: Diversification and rebalancing.

• Diversification. Portfolio diversification – spreading your investment dollars around into many different types of assets – can create a hedge against losses and help mitigate risk.
• Portfolio rebalancing. Over time, you will want to regularly rebalance your portfolio – re-allocating assets to different categories – to match changing economic conditions and changes in your appetite for risk as you approach retirement age.

Free Money! How to Maximize Your 401(k) Contributions

Saving as much money as you can while you are working can lead to fewer financial problems after retirement. Your employer also may match a certain percentage of your contributions, which is free money going into your retirement nest egg.

Here are some insights into maximizing your contributions and getting the most out of your 401(k).

Contribution limits

In 2025, the maximum dollar limit you can contribute to your traditional 401(k) is $23,500 unless you are over age 50, as set by IRC section 402(g).

Catch-up contributions

People over age 50 can make additional contributions up to the catch up contribution limit, raising the total contribution limit for 2025 to $31,000. People ages 60 and over, meanwhile, can contribute as much as $35,000.

Employer-matching programs

Employers have different types of 401(k) matching programs, and employer contribution types may vary. Some match your dollars equally, while others match up to a percentage. Small business owners may offer different matching arrangements or plan designs. Plans may have matching limits or a vesting schedule that requires employees to work a certain amount of time before they can own all employer-matching contributions.

Max-out contributions

One of the fastest ways to grow your 401(k) balance is to make the highest-possible contributions each pay period. The maximum contribution may be limited by a percentage of the employee’s compensation. You’ll get the added benefit of getting the most out of employer-matching contributions as well. You may have to scrimp a bit, or wait and make larger contributions as your salary grows, but making larger contributions will grow your balance and also increase your returns through higher compounded growth.

Know the Rules: 401(k) Contribution Limits and How They Affect You

The Internal Revenue Service (IRS) sets annual contribution limits for 401(k) plans to ensure these powerful retirement lan tools are used fairly and efficiently.

Knowing these limits is essential for anyone looking to maximize their 401(k) while steering clear of tax penalties. For 2025, the contribution limit for most workers is $23,500, with an additional catch-up contribution of $7,500 available for those aged 50 and older.

These limits apply to the combined total of your pre-tax and Roth 401(k) contributions. If you exceed these limits, you could face income taxes and additional tax penalties on the excess contributions, so it’s important to keep a close eye on your retirement savings strategy.

Annual Contribution Limits Explained

Annual contribution limits are in place to ensure that 401(k) plans benefit all employees, not just highly compensated employees. The IRS reviews and adjusts these limits each year to keep up with inflation and changes in the economy.

For example, the 401(k) contribution limit increased from $23,000 in 2024 to $23,500 in 2025. If you’re 50 or older, you can take advantage of catch-up contributions—an extra $7,500 in 2025—to help boost your retirement savings as you approach retirement age. These catch-up contributions are a great way for older workers to make up for any years they may not have been able to save as much.

Smart Strategies to Stay Within the Limits

To get the most out of your 401(k) while staying within the IRS contribution limits, consider these smart strategies:

1. Contribute Consistently: Set up regular contributions from each paycheck to steadily build your retirement savings without risking excess contributions.

2. Automate Your Contributions: Many employers offer automatic enrollment and automatic escalation features, making it easy to increase your contributions over time and take full advantage of any employer match.

3. Monitor Your Contributions: If you have more than one 401(k) plan in a year—perhaps due to changing jobs—be sure to track your total contributions across all plans to avoid exceeding the annual limit.

4. Consider Roth Contributions: If you want to pay income taxes now and enjoy tax-free withdrawals later, Roth 401(k) contributions are made with after-tax dollars. Qualified distributions from a Roth 401(k) are tax-free, which can be a big advantage in retirement.

5. Maximize Employer Match: Make sure you’re contributing enough to get the full employer match if your employer offers one. This is essentially free money added to your retirement account.

By understanding and following these contribution limits, you can avoid tax penalties and make the most of your 401(k) plan as you build your retirement nest egg.

Withdrawal Wisdom: How and When to Access Your 401(k) Savings

401(k) withdrawal rules are designed to encourage you to keep your retirement savings invested until you actually need them. Knowing when and how you can access your 401(k) funds can help you avoid unnecessary taxes and penalties, and ensure your retirement savings last as long as you need them.

Before Retirement

Generally, you can’t withdraw money from your 401(k) before age 59½ without facing a 10% early withdrawal penalty and paying regular income taxes on the amount you take out. There are some exceptions, such as unreimbursed medical expenses, permanent disability, or substantially equal payments under IRS rules, but these are limited and often require careful planning. Some 401(k) plans also allow for loans or hardship withdrawals, but these options can impact your long-term retirement plan and may still trigger income tax obligations.

After Retirement

Once you reach age 59½, you can withdraw funds from your 401(k) without the early withdrawal penalty, though you’ll still pay income taxes on traditional 401(k) distributions. Qualified distributions are tax-free if you have a Roth 401(k), provided you’ve held the account for at least five years. After you turn 73 (or 75, depending on your birth year), the IRS requires you to start taking required minimum distributions (RMDs) from your 401(k) each year. Failing to take your RMDs can result in steep tax penalties, so carefully planning your withdrawals is important.

Tips for Managing Withdrawals:

• Plan for Taxes: Remember that traditional 401(k) withdrawals are taxed as ordinary income. Work with a tax professional to minimize your tax liability and avoid surprises.
• Consider Your Retirement Income Needs: Withdraw only what you need to cover your retirement expenses, so your remaining plan assets can continue to grow.
• Coordinate with Other Retirement Plans: If you have multiple retirement accounts, such as an IRA or Roth IRA, develop a withdrawal strategy that maximizes your tax advantages and meets your income needs.
• Avoid Unnecessary Penalties: Only take early withdrawals if absolutely necessary, and explore all available exceptions or alternatives first.

By understanding the withdrawal rules for 401(k) plans, you can make informed decisions about when and how to access your retirement savings, helping you enjoy a more secure and comfortable retirement.

Beyond the 401(k): Other Ways to Save for Retirement

Employer-sponsored retirement savings plans offer a convenient and proven way of building retirement wealth. In addition to these, government programs such as Social Security can supplement personal retirement savings and help fill potential gaps. While 401(k)s are a popular defined-contribution plan, traditional defined benefit pension plans provide guaranteed retirement income and greater security, as they do not expose individuals to investment risks. Consider these other options as well.

Individual Retirement Accounts (IRAs)

Individual retirement accounts are tax-advantaged savings plans offered by financial institutions for personal retirement savers. These accounts are governed by specific sections of the internal revenue code, which establish the rules and tax treatments for different types of IRAs.

There are traditional and Roth IRAs, as well as rollover IRAs where you use money from an old 401(k) plan. IRAs have different tax advantages. Traditional IRAs allow you to potentially deduct pre-tax contributions from ordinary income, which may lower your annual tax liability. Taxes are deferred until you begin taking deductions in retirement, but by then you most likely will be in a lower tax bracket than when you were working.

With Roth IRA’s, contributions are made with post-tax dollars, but any growth realized may result in tax-free deductions upon retirement when you meet certain conditions.

Health Savings Accounts (HSAs)

Health savings accounts allow you to contribute pre-tax dollars into an account specifically intended to pay for qualified medical expenses.

Since you own the account, your savings can rollover year-after-year and grow tax-free. HSA contribution limits in 2025 are $4,300 for individuals and $8,550 for families. People ages 55 and up can contribute an additional $1,000 annual to their HSAs.

Avoid These 401(k) Pitfalls and Build a Stronger Financial Future

For most people, maximizing your 401(k) contributions will take a little work and some serious scrimping. The financial sacrifices made each year will pay off in spades down the road in the form of a much larger 401(k) balance.

Avoid these common 401(k) pitfalls to ensure you are building the strongest financial future possible. If you need to make an early withdrawal, remember that financial hardship is one of the exceptions that may allow penalty-free access to your 401(k) funds. However, even if you qualify for an exception, you may still owe required income taxes on the amount withdrawn.

Not starting early

Time and compound interest are two of the best tools you can use to grow your retirement wealth. If you save $2,000 every year starting at age 20, and you retire at age 65, you’ll contribute $90,000 to your 401(k). At 5 percent annual interest, that $90,000 will be about $320,000. That nest egg dips to $180,000 if you start saving the same amount at age 30, and it’s just over $95,000 if you start saving at age 40.

Overlooking employer matching contributions

Employer-matching contributions to your 401(k) may be as much as 5% of your annual salary. Don’t leave this free money sitting on the sidelines.

Early withdrawals

No matter how financially pinched you may become, resist the urge to tap into your retirement funds. You may be penalized by the Internal Revenue Service, and you’ll owe income tax on your distribution as well. You’ll also be robbing yourself of the added power of compounded growth with a lower 401(k) balance.

Other common 401(k) pitfalls to avoid include not routinely checking your investment options to ensure maximum gains through rebalancing, leaving a job before meeting employer vesting requirements, and not knowing which asset classes your money is invested in.

Take Charge of Your Retirement: Start Your 401(k) Journey Today

Retirement savings accounts like 401(k)s are one of the safest and simplest ways to build wealth for retirement. Millions of Americans have money automatically deducted from their paychecks to grow their 401(k) balances.

While starting early is important, it’s really never too late to start your 401(k) journey. You may already be automatically enrolled in your company’s 401(k) savings plan due to new laws that took effect in 2025. If choosing where to spread your investment dollars is difficult or confusing, consult with your company’s human resource department or a financial professional to determine which investment options align with your appetite for risk and personal investment philosophies.

FAQ