What Is a 401(k)? How It Works, Limits, and Withdrawals

A 401k is an employer-sponsored retirement account that lets you invest part of your paycheck, usually before income tax is taken out, and often with matching contributions from your employer. You enroll through work, pick how much comes out of each check, and choose investments from a menu the plan offers. In 2026, you can contribute up to $24,500 of your own salary, with higher limits if you’re 50 or older.1Internal Revenue Service. 401(k) Limit Increases to $24,500 for 2026, IRA Limit Increases to $7,500

How a 401k Actually Works

You authorize your employer to withhold a dollar amount or percentage from each paycheck and send it to an investment account managed by a plan administrator, typically a firm like Fidelity, Vanguard, or Schwab. The money never passes through your checking account, so once you’ve enrolled, saving happens automatically every pay cycle.

Inside the account, you choose investments from the plan’s lineup. Options usually include stock funds, bond funds, and target-date funds that gradually shift from aggressive to conservative holdings as you near retirement. Each fund carries an expense ratio, and those fees matter: the Department of Labor estimates a 1% difference in annual fees can reduce your final balance by roughly 28% over a 35-year career.2U.S. Department of Labor. A Look at 401(k) Plan Fees Your plan is required to disclose fees at least annually, and actual charges appear on quarterly statements.3U.S. Department of Labor. Final Rule to Improve Transparency of Fees and Expenses to Workers in 401(k)-Type Retirement Plans Index funds generally charge far less than actively managed ones.

Traditional vs. Roth: When You Pay the Tax

Most plans let you split contributions between two tax treatments. The question is simply when you’d rather pay income tax on the money.

With traditional contributions, the money comes out before income tax is calculated. A $500 contribution on a $2,000 paycheck means the IRS only taxes you on $1,500 that period. You get the tax break now, but when you withdraw in retirement, every dollar (contributions plus growth) is taxed as ordinary income.

Roth contributions flip the order. You pay income tax on the full paycheck first, then the money goes into the account. Both the contributions and all future growth come out completely tax-free in retirement, provided you’ve held the account at least five years and are 59½ or older.4Office of the Law Revision Counsel. 26 U.S. Code 402A – Optional Treatment of Elective Deferrals as Roth Contributions Starting in 2024, Roth 401k accounts are no longer subject to required minimum distributions under SECURE 2.0.

Which to pick depends on where you think your tax rate is headed. If you expect to earn more later, Roth locks in today’s lower rate. If you’re in peak earning years and expect a lower bracket in retirement, traditional gives you the bigger break now. Splitting between the two is a common hedge.

Employer Matching and Vesting

Many employers add money on top of what you contribute. A typical formula puts in fifty cents for every dollar you contribute, up to 6% of your pay. On an $80,000 salary, contributing 6% ($4,800) would get you another $2,400 from the employer. Contributing less than the amount needed to capture the full match leaves compensation on the table.

Your own contributions always belong to you immediately. Employer contributions often come with a vesting schedule — a waiting period before you fully own them. Federal law caps how long employers can make you wait:5Office of the Law Revision Counsel. 26 USC 411 – Minimum Vesting Standards

  • Cliff vesting: you own 0% of employer contributions until three years of service, then 100% all at once.
  • Graded vesting: ownership phases in from 20% at two years, rising 20 points per year, reaching 100% at year six.

Leaving before you’re fully vested means forfeiting the unvested portion. A few extra months on the job can be worth thousands in match dollars you’d otherwise lose.

2026 Contribution Limits

The IRS caps how much can go into a 401k each year, with inflation adjustments. For 2026:

Taking Money Out

A 401k is built to stay invested until retirement. The IRS enforces that with a 10% early withdrawal penalty on top of regular income tax for any distribution before age 59½.7Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions Between the penalty and the taxes, an early withdrawal can lose 30 to 40% of whatever you pull out.

The Rule of 55

If you leave your job during or after the year you turn 55, you can withdraw from that employer’s 401k without the 10% penalty. The exception only covers the plan held by the employer you just separated from, not old plans from previous jobs and not IRAs. For public safety employees in government plans, the age drops to 50. Regular income tax still applies.

Hardship Withdrawals

Some plans allow early withdrawals for specific emergencies without requiring you to quit. The IRS recognizes several qualifying hardships, including medical expenses, costs to prevent eviction or foreclosure, funeral expenses, and certain disaster-related losses.8Internal Revenue Service. Retirement Topics – Hardship Distributions You still owe income tax, and the 10% penalty may still apply depending on your age. Hardship money also can’t be put back in later; it’s permanently gone from your retirement savings.

Required Minimum Distributions

You can’t leave money in a traditional 401k forever. The IRS requires withdrawals, called required minimum distributions, once you reach age 73.9Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs If you’re still working at that age and don’t own 5% or more of the company, you can delay RMDs from your current employer’s plan until you actually retire. Under SECURE 2.0, the RMD age rises to 75 starting in 2033. Roth 401k accounts are exempt from RMDs entirely as of 2024.

Loans and Rollovers When You Change Jobs

Many plans let you borrow from your own balance instead of taking a taxable distribution. The maximum loan is the lesser of $50,000 or 50% of your vested balance, repaid with interest back into your own account, generally within five years. Loans used to buy a primary residence can run longer.10Internal Revenue Service. Retirement Topics – Plan Loans

The risk is losing your job. If you separate with an outstanding loan, you typically have 60 to 90 days to repay the full balance. Fail to repay, and the unpaid amount is treated as a distribution, triggering income tax and the 10% penalty if you’re under 59½.

When you leave an employer, you have several choices for the account itself. A direct rollover sends your balance straight to a new employer’s plan or to an IRA, with no taxes, no withholding, and no deadline.11Internal Revenue Service. Rollovers of Retirement Plan and IRA Distributions An indirect rollover, where the plan cuts you a check, is riskier: the administrator withholds 20% for federal taxes, and you have 60 days to deposit the entire original balance (including the withheld portion, out of pocket) into another retirement account. Miss the window, and the whole thing becomes a taxable distribution.

You can also leave the money in your old employer’s plan if your balance exceeds $7,000, or cash out. Cashing out before 59½ triggers full taxation plus the 10% penalty, which can take nearly half the balance. A direct rollover to an IRA usually offers the widest investment selection and the lowest fees.

The Saver’s Credit

Lower- and moderate-income workers who contribute to a 401k may qualify for a direct tax credit worth up to 50% of the first $2,000 contributed ($4,000 for married couples filing jointly). The credit rate drops in tiers of 50%, 20%, or 10% based on adjusted gross income and filing status.12Internal Revenue Service. Retirement Savings Contributions Credit (Saver’s Credit) Income thresholds adjust annually, so check the IRS page for the current year’s cutoffs before assuming you qualify. A credit reduces your tax bill dollar for dollar, which means that for workers in the income range, a 401k contribution can earn both an employer match and a government bonus on the same money.