Contact

What is a 401K Plan and How Does a 401(K) Work?

Table of Contents

Save thousands each year, and gain control of what's yours.

Speak to Our Expert

Join our newsletter
to get trending content!

Teaming up with your employer to save for retirement can be one of the smartest financial moves you make. That’s where a 401(k) plan comes in. If you’ve ever wondered “What is a 401(k)?” or how it helps you build long-term wealth, this guide is for you.

What is a
401(k) Plan?

A 401(k) is a tax-advantaged retirement savings plan offered by employers. Named after a section of the U.S. Internal Revenue Code, it allows employees to save and invest a portion of their paycheck before or after taxes, depending on the type of 401(k) plan.

Key Takeaways

Feature 401(k) Plan (2025)
Who Can Participate Any employee whose employer offers it
Contribution Type Pre-tax (traditional)
Withdrawal Taxation Taxed as ordinary income
Employee Contribution Limit (Age under 50) $23,500
Catch-Up Contribution (Age 50+) $7,500
Combined Employee + Employer Limit $70,000
Annual Compensation Cap $350,000
Highly Compensated Employee Threshold $160,000
Early Withdrawal Rules Penalty-free after age 59½
Required Minimum Distribution Age 73 years
Key Advantages Tax breaks, high contribution limits
Key Disadvantages Fees, limited investment choices, mandatory withdrawals

How Does a 401(k) Work?

When you enroll in a 401(k), you decide how much of your paycheque you want to contribute. That money is automatically deducted and deposited into your 401(k) account. You can typically choose how to invest it in mutual funds, ETFs, or other options provided in the plan.
Your money grows tax-deferred, meaning you don’t pay taxes on gains until you withdraw the funds (or, in the case of a Roth 401(k), you may pay no taxes at all when withdrawing in retirement).

401(K) Benefits

The benefits of investing in a 401(k) plan are
  • Control over when taxes are paid on retirement assets (pre-tax versus post-tax Roth contributions)
  • Employers may offer to match a portion of what you contribute
  • Higher contribution amounts than allowed in SIMPLE IRA or SEP plans
  • Tax-deferred growth on investments while in the 401(k) plan
  • Option to take a loan from retirement savings
  • Ability to transfer assets to other retirement accounts when retiring or changing jobs
  • Reduced taxable income through pre-tax salary contributions
  • Disciplined savings through automatic payroll deductions
  • Access to a wide range of investment options
  • Tax credits for some employees

What are the Types of 401(k) Plans?

There’s no one-size-fits-all approach when it comes to retirement planning. Here are the most common 401(k) plan types:
Here’s an elaborated explanation of each retirement plan in 4-5 lines:

Traditional 401(k) Plans

A traditional 401(k) lets employees contribute a portion of their pre-tax income to a retirement account, reducing their taxable income for the year. Employers may choose to match a percentage of employee contributions, boosting overall savings.
Taxes on contributions and investment gains are deferred until withdrawal, typically in retirement. This plan is the most common option offered by employers.

Best for
  • Any private or public company, but best for companies with 20 or more employees.

Key advantage
  • Flexible
  • Offers a wide range of mutual fund investment options
  • Allows small business owner to change the employer contribution amount every year
  • Allows high level of salary deferrals by employees

Who can contribute
  • Employee deferrals and employer contributions.

Tax advantage
  • For employees, contributions are pre-tax contributions and growth is tax-deferred
  • For employers, contributions are tax-deductible

Roth 401(k) Plans

A Roth 401(k) plan combines features of a traditional 401(k) with the tax benefits of a Roth IRA. Contributions are made with after-tax dollars, but qualified withdrawals in retirement are completely tax-free.
This option is ideal if you expect your tax rate to be higher in retirement or want to avoid paying taxes on investment gains later. Many employers offer Roth and traditional 401(k) options side by side.

Best for
  • High-income earners

Key advantage
  • Adding a Roth to your 401(k) opens you up to a new tax diversification strategy. This means no income cap for contributing to a Roth 401(k)
  • Attracts employees, particularly high-earners and millennials
  • The cost of adding a Roth to your existing company 401(k) is very low

Who can contribute to Roth 401(K) Plan
  • Employee deferrals and employer contributions.

Tax advantage
  • Employee contributions are made with after-tax dollars. However, the income earned on the account (from dividends, interest or capital gains) is tax-free.

SIMPLE 401(k) Plans

SIMPLE 401(k) plans are designed for small businesses with 100 or fewer employees. They combine features of a traditional 401(k) with simplified administration and lower costs.
Employers are required to make either matching contributions or fixed non-elective contributions for all eligible employees. All contributions are immediately vested, making this plan straightforward and employee-friendly.

Best for
  • Small business owners with 100 or less employees who earn $5,000 or more per year.

Key Advantages
  • No discrimination tests and relatively easy to administer
  • Designed for greater flexibility to meet a plan sponsor’s unique needs
  • Ability to incorporate profit-sharing
  • Ability to add a loan provision

Who can contribute to simple 401(K) plan
  • Employee deferrals and employer contributions.

Tax advantage
  • Contributions have tax-deferred growth potential

Solo 401(k) or Self-Employed 401(k) Plans

A Solo 401(k) is designed for self-employed individuals or business owners with no employees (other than a spouse). This plan allows you to contribute both as an employee and an employer, maximizing the total contribution limit.
You can choose between traditional pre-tax or Roth after-tax contributions, offering flexibility for tax planning. It’s one of the most powerful retirement savings tools for entrepreneurs.

Best for
  • Self-employed consultants and contractors, sole proprietors, and small business owners, or individuals with no employees (except for partners and spouse).

Key advantage
  • Higher contribution limits than SEP IRA
  • Wide investment options

Who can contribute to solo 401(K)/ self employed 401(K)
  • Employee deferrals and employer contributions.

Tax advantage
  • For employer, the contributions are tax-deductible
  • The growth of contributions is tax-deferred

Safe Harbor 401(k) Plans

Safe harbor 401(k) plans are designed to automatically meet IRS non-discrimination requirements, making them easier for employers to manage. Employers must make mandatory contributions, either matching or non-elective, to all eligible employees.
These contributions are immediately 100% vested, meaning employees own them right away. This plan is ideal for businesses that want to avoid complex annual testing.

Best for
  • High-earning employees of small businesses and business owners, who are willing to invest aggressively in their retirement accounts.

Key advantage
  • Avoids most annual compliance testing
  • Maximizes you and your high-earning employees’ personal retirement savings

Who can contribute to Safe Harbor 401(K)
  • Employee deferrals and employer contributions.

Tax advantage
  • Allows pre-tax / post-tax contributions

403(b) Plans

Although technically for public schools and certain non-profit organizations, 403(b) plans work similarly to 401(k)s. Employees can contribute pre-tax income, and employers may offer matching contributions.
These plans often have lower administrative costs and may include special catch-up provisions for long-term employees. They are an attractive option for those in the education or non-profit sectors.

Best for
  • Any company meeting the plan’s eligibility criteria

Key Advantages
  • Enables employers to offer matching benefits, hence helps in attracting and retaining employees
  • Funds in 403(b) grow tax-deferred for decades. Taxes are applicable only when the owner begins to withdraw from the account

Who can contribute to 403(b) plans
  • Employee deferrals and employer contributions.

Tax advantage
  • Tax-deferred contributions until withdrawn. The retirement plan can also include contributions that are made ‘after-tax.’

Profit Sharing 401(k) Plans

In a profit-sharing 401(k), employers can make discretionary contributions to employee accounts based on company profits. Contributions are flexible, so the amount can vary from year to year depending on the business’s financial performance.
Employees can also make elective deferrals, combining the benefits of profit sharing with traditional 401(k) savings. This plan works well for companies that want to reward employees during profitable years.

Best for
  • Self-employed professionals and small business owners with employees less than 100

Key Advantages
  • Employers can make large contributions for employees

Who can contribute to profit sharing plans
  • Solely by employer contributions.

Tax advantage
  • Tax-deferred growth
  • For employer, contributions are tax-deductible

How to Start a 401k?

Starting a 401(k) is one of the most effective ways to build long-term retirement savings, especially if your employer offers matching contributions. The process is straightforward, but understanding each step ensures you get the maximum benefit.

Check Employer Availability

Most 401(k) plans are offered through employers. Confirm if your company provides a 401(k) plan and whether they offer a match on your contributions. If you’re self-employed, you may be eligible for a Solo 401(k).

Enroll in the Plan

Once eligible, complete your company’s enrollment process. This usually includes filling out a participation form and choosing your contribution percentage.

Decide Contribution Amount

  • For 2025, you can contribute up to $23,500 (under age 50).
  • If you’re 50 or older, you can make an additional $7,500 catch-up contribution.
  • Aim to contribute at least enough to get the full employer match it’s essentially free money.

Choose Investment Options

Your 401(k) custodian (usually through your employer) will provide a menu of investments, often including mutual funds, index funds, and target-date funds. Pick a mix that aligns with your risk tolerance, age, and retirement goals.

Review Plan Fees

Understand the plan’s administrative and fund management fees. Even small differences in fees can impact your retirement balance over time.

Automate Contributions

Contributions are automatically deducted from your paycheck pre-tax (or post-tax if you choose a Roth 401(k) option). This makes saving effortless and consistent.

Monitor and Adjust

Review your plan at least once a year. Increase contributions as your salary grows, and adjust investments if your risk tolerance or retirement timeline changes.

What is Employer Matching in a 401(k)?

Employer matching is one of the biggest advantages of a 401(k)—it’s essentially free money your company adds to your retirement savings.

How it Works

For every dollar you contribute, your employer may also contribute, up to a limit. Example: 50¢ for every $1 you put in, up to 6% of your salary.

Why it Matters

Contributing enough to get the full match is like getting an instant return on your money-missing it is leaving free money on the table.

Not Part of Your Limit

Employer contributions don’t count toward your $23,500 annual limit (2025). They do count toward the combined total ($70,000 for 2025).

Dollar-for-dollar matches

Some employers match 100% of your contributions, usually up to 3–4% of your salary.

Vesting Rules

Some plans require you to stay with the company for a certain time before the match is fully yours.

What are the Contribution Limits for a 401(k)?

The IRS sets annual limits on how much you can contribute to your 401(k). Knowing these caps helps you plan your savings and avoid penalties.
  • Employee Contribution Limit (2025): You can contribute up to $23,500 if you are under age 50.
  • Catch-Up Contributions: If you’re 50 or older, you can put in an extra $7,500, raising your total to $31,500.
  • Employer Contributions: Your employer match does not count toward your personal $23,500 limit, but it does count toward the overall plan cap.
  • Combined Total Limit (2025): The maximum combined contribution (you + employer) is $70,000 or $77,500 if you’re 50 or older with catch-up.
  • Compensation Cap: Only the first $350,000 of income (2025) can be considered when calculating employer contributions.
Tip: Even if you can’t max out your contributions, try to contribute at least enough to get the full employer match-it’s one of the best ways to grow your retirement savings.

How Do 401(k) Withdrawals Work?

Money in a 401(k) is meant for retirement, and accessing it early can trigger taxes and penalties. Here’s what you need to know:
  • Standard Withdrawals: Allowed from age 59½. Traditional 401(k) withdrawals are taxed as ordinary income. Roth 401(k) withdrawals are tax-free if requirements are met.
  • Early Withdrawals (<59½): Subject to 10% penalty plus taxes, unless you qualify for an exception.
  • Hardship Withdrawals: If your plan allows, you may take money out for specific needs like medical expenses, college tuition, home purchase/repairs, foreclosure prevention, or funeral costs. Proof of hardship is required.
  • Penalty-Free Exceptions: Disability, large medical expenses, court orders (QDRO), certain disasters, or substantially equal periodic payments (SEPP). Taxes still apply.
  • Required Minimum Distributions (RMDs): Starting April 1 of the year after you turn 73, you must begin annual withdrawals. Missing an RMD can result in steep IRS penalties.
  • Retirement Distributions: After 59½, you can take lump sums or periodic payments. Lump sums are taxable immediately and reduce your nest egg, while periodic payments help stretch savings longer.

What Are Required Minimum Distributions (RMDs) in a 401(k)?

RMD Age Requirement

Starting in 2023, the IRS raised the RMD age to 73. That means once you reach 73, you must begin taking distributions from your traditional 401(k) - unless your plan allows you to delay until retirement and you’re still working (and not a 5% business owner).

First Withdrawal Deadline

Your first RMD is due by April 1 of the year after you turn 73. If you delay past that, you'll also need to take your next year's RMD by December 31 of the same year.

Subsequent Withdrawals

After the initial RMD, all following distributions must be taken by December 31 each year.

Working Exception (Most Cases)

If you’re still employed and don’t own more than 5% of the company, you may be permitted to delay RMDs until retirement - depending on your plan rules.

Calculation Method

RMD amounts are determined using IRS life expectancy tables. You divide your December 31 account balance by the appropriate “distribution period” from the Uniform Lifetime Table (or other applicable tables) to find your RMD.

Penalty for Missing RMD

A steep penalty applies if you don’t take your full RMD on time - 25% of the amount not withdrawn, which can be reduced to 10% if corrected within a specific timeframe.

What are the Investment Options of 401k?

Your 401(k) investment choices depend on your employer’s plan and provider. Most plans offer 8–12 options, with at least three required by law.

Common Options

Mutual funds (stock, bond, balanced, and target-date funds) are the most popular.

Other Choices

Stable value funds, guaranteed investment contracts (GICs), company stock, or variable annuities.

Brokerage Windows

Some plans let you invest in a wider range of assets like stocks, bonds, and ETFs.

Tip: Build a diversified mix that aligns with your goals, time horizon, and risk tolerance.

Take Control of Your Retirement Future

Whether you are looking to start a 401(k), roll over an existing plan, or explore self-directed retirement options, Self-Directed Retirement Plans can help. Our experts provide tailored solutions that put you in control of your financial future.

Schedule a Free Consultation Today

FAQs About 401(k)s

  • Check eligibility (usually age 21 + 1 year of service).
  • Fill enrollment forms and name a beneficiary.
  • Choose Traditional vs Roth 401(k).
  • Decide contribution % (at least enough to get the full employer match).
  • Contributions come directly from your paycheck.

  • 401(k): Employer-sponsored, higher contribution limits ($23,500 in 2025), possible employer match, but limited investment choices.
  • IRA: Opened individually, lower contribution limits ($7,000 in 2025), no employer match, but wider investment flexibility.

  • 401(k): Contributions are made pre-tax, lowering your taxable income today. Withdrawals in retirement are taxed as ordinary income.
  • Roth 401(k): Contributions are made after-tax (no deduction now). Qualified withdrawals in retirement are tax-free.
  • In short: Choose a 401(k) if you want tax savings today, and a Roth 401(k) if you’d rather pay taxes now for tax-free income later.

When you retire, you can start taking money from your 401(k) at age 59½ without penalty. 401(k) withdrawals are taxed as income, Roth 401(k) withdrawals are tax-free if rules are met, and at age 73 you must start Required Minimum Distributions (RMDs) from a Traditional 401(k).

For 2025, the 401(k) contribution limit is $23,500, with catch-ups of $7,500 (age 50+) and $11,250 (ages 60–63). The total employee + employer cap is $70,000, plus new rules require auto-enrollment and faster access for part-time workers.

A 401(k) loan lets you borrow up to 50% of your vested balance (max $50,000), repayable in 5 years or longer for a home purchase. If not repaid, the balance is treated as a taxable distribution with penalties.

A 401(k) rollover is when you move money from your old 401(k) into a new 401(k) plan or an IRA to keep your savings tax-deferred and growing. Done correctly, it avoids taxes and penalties.

When you change employers, you can (1) leave your money in the old 401(k) if allowed, (2) roll it into your new employer’s 401(k), (3) roll it into an IRA for more control, or (4) cash it out—though cashing out triggers taxes and penalties if you’re under 59½.

You have a few options:

  • Leave it in your former employer’s plan
  • Roll it over into a new employer’s plan
  • Move it into an IRA
  • Cash out (but penalties and taxes may apply)

Unless an exception applies, early withdrawals (before 59½) come with a 10% penalty and are taxed as income.

Yes! You can contribute to both, but income limits may affect whether your IRA contributions are tax-deductible.

Diversify based on your age, risk tolerance, and retirement timeline. A mix of index funds, bonds, and stocks often works well. Consider target-date funds if you prefer a hands-off approach.

Download Self Directed IRA Setup Guide

This field is for validation purposes and should be left unchanged.

Download Self Directed 401k Application Guides

This field is for validation purposes and should be left unchanged.