Understanding 401(k): A Complete Guide to Employer-Sponsored Retirement Plans

What is a 401(k) and How Does It Work?

A 401(k) gets its name from section 401(k) of the U.S. Internal Revenue Code, which establishes the framework for this retirement savings vehicle. At its core, a 401(k) is an employer-sponsored retirement account where employees automatically contribute a portion of their salary before or after taxes, depending on the plan type.

When you enroll in a company’s 401(k) plan, you authorize your employer to withhold a percentage of your paycheck. The key benefit: many employers match your contributions—either partially or fully. This employer match is essentially free money for retirement, making it one of the most valuable aspects of retirement planning through your workplace.

Two Paths: Traditional vs. Roth 401(k)

The two main 401(k) variants differ primarily in how taxes are handled.

Traditional 401(k): Your contributions come straight from your paycheck before income taxes are applied. This reduces your current taxable income, lowering the taxes you owe immediately. However, when you withdraw during retirement, those distributions are taxed as ordinary income. Early withdrawals before age 59½ trigger a 10% penalty (with limited hardship exceptions for situations like eviction or funeral costs). For 2022, traditional 401(k)s have an income ceiling of $305,000, which affects employer matching eligibility.

Roth 401(k): Contributions are made after taxes, meaning no immediate tax deduction. The tradeoff: qualified withdrawals during retirement—both your contributions and investment gains—come out completely tax-free. Unlike traditional plans, Roth 401(k)s have no income limits, making them accessible regardless of earnings level.

Maximizing Your Contributions

Annual contribution limits change yearly based on inflation. For 2022, the IRS raised the employee contribution limit to $20,500 (up from $19,500 in 2021). Workers aged 50 and older can make additional “catch-up” contributions of up to $6,500 annually, bringing their total possible contribution to $27,000.

How much should you contribute? At minimum, contribute enough to capture your employer’s full match—if they offer 3%, you should contribute 3% to receive that benefit. Financial advisors typically recommend aiming for 10-15% of your gross salary (including employer match) to build adequate retirement reserves.

If you max out your 401(k) and want to save more, an Individual Retirement Account (IRA) complements your retirement strategy. Note: IRA contributions may lose tax deductibility if your salary exceeds certain thresholds while maintaining a traditional 401(k).

What Happens When You Change Jobs?

Changing employers requires strategic decisions about your 401(k):

Transferring to a new employer: If your new employer accepts rollovers, you can transfer your 401(k) without fees—a recommended move if your balance exceeds $5,000. Balances below $1,000 may be distributed as a check by your former employer.

Leaving your account in place: You can maintain your current 401(k) with your previous employer’s plan, though you cannot make new contributions. Your new employer may impose a waiting period before their 401(k) benefits activate.

Rolling into an IRA: Convert your existing 401(k) into a rollover IRA if your new employer doesn’t offer a 401(k) plan. This preserves tax-deferred status without withdrawal penalties and provides broader investment flexibility.

What Happens When You Leave Your Job?

Once you quit, you cannot contribute to your employer-tied 401(k) anymore. Your options depend on your balance:

• Under $1,000: Your employer may close the account and mail a check, though you can redirect these funds to a rollover IRA instead to avoid penalties.
• $1,000 to $5,000: Your employer can roll your 401(k) into an IRA automatically.
• $5,000 or more: Transfer to a rollover IRA to avoid early withdrawal fees and maintain tax advantages.
• Keep it: Some plans allow inactive accounts to remain untouched if your employer permits.

Remember: vesting—your ownership of employer contributions—must reach 100% at retirement or plan termination per IRS rules.

Managing Your 401(k) After Death

If you’re married and name your spouse as beneficiary, they have flexibility: manage and withdraw from the account, roll it into their own 401(k), or take the full distribution. Importantly, surviving spouses avoid the 10% early withdrawal penalty if withdrawing before age 59½.

If your beneficiary is not your spouse, they must choose between:

• Keeping the account and withdrawing required minimum distributions (RMDs) by December 31st of the year following your death
• Closing the account and taking all funds within 5 years

For non-spouse beneficiaries, RMDs are calculated based on life expectancy and reported on tax returns.

When Can You Withdraw Without Penalties?

Penalty-free withdrawals begin at age 59½. However, there’s an important exception: if you retire or lose employment at age 55, you can withdraw from your current employer’s 401(k) without the 10% early withdrawal penalty (this doesn’t apply to 401(k)s from past employers).

Hardship withdrawals allow penalty-free access for genuine emergencies:

• Primary home down payment
• Avoiding eviction or covering primary residence repairs
• Medical expenses for you, your spouse, dependents, or beneficiaries
• Funeral expenses
• College tuition and room-and-board costs

Example calculation: A single California resident earning $78,000 withdrawing $20,000 faces $4,400 federal income tax (22%), $2,000 penalty (10%), and $1,600 state income tax (8%)—totaling $8,000 in taxes and leaving $12,000 net.

Required Minimum Distributions: The 72-Year Rule

At age 72 (or 70½ if you reached that age before January 20, 2020), you must start taking RMDs from your 401(k) unless still employed. This rule aims to ensure retirement funds eventually get distributed. RMDs are calculated using your life expectancy and taxed as ordinary income. The exception: business owners with more than 5% company ownership may have different rules.

401(k) vs. IRA: Key Differences

While both provide tax-advantaged retirement savings, they function differently:

401(k)s are tied to your employer, often include employer matching contributions, and allow up to $20,500 in annual contributions ($27,000 if 50+). Investment options are limited to what your plan offers, but you can continue contributing after age 72 if still employed. Self-employed individuals can set up solo 401(k)s.

IRAs operate independently from employment, offer no employer match, but provide broader investment choice. 2022 contribution limits are $6,000 ($7,000 if 50+). You cannot make new IRA contributions once retired or unemployed, but unlike 401(k)s, prior-year contributions can be made during retirement for tax filing purposes.

401(k) Pros and Cons

Advantages: High contribution limits ($20,500 annually), reduced current taxable income with traditional plans, automatic payroll deductions simplify saving, continued contributions available after age 72 if working, and accessibility for self-employed individuals.

Disadvantages: Limited investment selection compared to IRAs, potential fees that reduce returns, and contribution eligibility tied to employment status.

Frequently Asked Questions

How much should I have in my 401(k)? There’s no universal target—it depends on your lifestyle and retirement goals. For 2022, maximum contributions reach $20,500 (plus $6,500 for age 50+). A common benchmark suggests having 1x your salary by 30, 3x by 40, 6x by 50, 8x by 60, and 10x by 67.

Should I prioritize 401(k) or other investments? Start by contributing enough to capture your employer match, then balance between maxing your 401(k), funding an IRA, and exploring additional investment vehicles like taxable brokerage accounts or alternative assets.

Can I withdraw early? Yes, but a 10% penalty applies before 59½ (except at age 55 upon job separation). Hardship withdrawals and specific life circumstances qualify for penalty exceptions, though ordinary income taxes still apply.

A 401(k) remains one of the most accessible wealth-building tools for retirement, combining tax advantages, employer matching, and automatic contribution discipline—making it a cornerstone of most retirement strategies.