What Is a 401(k)? Pros and Cons

Written by Dayana Yochim
Edited by Carolyn Kimball
Fact-checked by Andrea Coombes

December 04, 2024

A 401(k) is a tax-advantaged retirement savings plan offered by many U.S. employers. It is designed to help workers grow their savings for retirement. Contributions are deducted directly from your paycheck, making it a simple and efficient way to save for the future while reducing your taxable income today. Similar plans for teachers, nonprofit employees and government workers include 403(b)s and 457s.

In this guide, we’ll explore the benefits and potential downsides of 401(k) plans. From understanding how tax breaks work to tips for maximizing employer contributions and investment options, you’ll gain a clear picture of how a 401(k) can fit into your retirement strategy. Whether you're just starting your career or looking to fine-tune your financial plan, this resource has you covered.

Pros and cons of 401(k)s

Even if your 401(k) plan has no “matching” component, this account type still provides savers a great way to grow retirement savings, tax-free (on top of the tax breaks you get on either contributions or withdrawals).

thumb_up_off_alt Pros

Employer matching. Employer contributions – either as a percentage or a deposit – are the prime perk of 401(k)s.
High contribution limits. The IRS allows contributions up to $23,000 a year ($30,500 if you’re 50 or older) in a 401(k) in 2024.
Early retirement withdrawals. If you’re retiring, the IRS lets you take penalty-free (not tax-free) distributions from your 401(k) starting at age 55 (instead of 59½).
Take out a loan against your balance. Some plans allow you to borrow against the money in your 401(k) and pay it back to yourself (typically within five years, with interest).
Access to a Roth account. Many employer-sponsored 401(k) plans adopt a Roth feature – this means you get to choose when you want your tax break.

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Waiting periods. New employees may have to wait (a few months or up to a full year) before making contributions, and matched contributions may be subject to a vesting schedule.
Not all employees are eligible. Some 401(k)s limit access to full-time employees only.
There may be no company match. Employers are not legally required to offer a 401(k) match program.
401(k) plan fees. 401(k) admin fees can range from less than 1% to more than 2%, depending on the assets and number of participants.
You must start withdrawing money at age 72 or 73. Unless you're still working at the company, you’ll have to start taking required minimum distributions from your 401(k) at age 72 (or 73 if you reach age 72 after Dec. 31, 2022).

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How 401(k)s can help you save for retirement

401(k) plans offer three key features that can significantly enhance your retirement savings:

First, 401(k)s provide a substantial tax advantage by deferring taxes on your contributions and investment growth. Funds within the account are sheltered from taxation for as long as they remain invested, potentially spanning decades. This tax-deferred growth allows your savings to compound more effectively, free from the immediate impact of capital gains or dividend taxes.
Second, 401(k)s offer flexibility in tax benefits, depending on the type of account you choose. With a traditional 401(k), contributions are made pre-tax, reducing your taxable income for the year. In contrast, Roth 401(k) contributions are made with after-tax dollars, but withdrawals in retirement, including all earnings, are entirely tax-free. Both options provide valuable tools for tax planning, allowing you to select the approach that best suits your financial goals. Note that some employers may only offer a traditional 401(k) plan.
Finally, many employers enhance their employees’ retirement savings through matching contributions. Known as a “company match,” this feature provides additional funds — often based on a percentage of your salary — at no cost to you. These contributions are essentially extra compensation and a powerful incentive to maximize your own contributions to take full advantage of this benefit.

Example: If you make $75,000 a year and contribute 10% of your salary ($7,500), an employer offering a 4% match brings your annual 401(k) balance to $10,500. That’s a 40% return on money in the first year, even before taking into account investment gains. (Some particularly benevolent employers kick in money even if you don’t contribute.) The company match is the reason we recommend that, if you have access to a 401(k) with a match, you start your retirement savings journey with that account. It’s like hitting an investing home run on your first at-bat. (If your company doesn’t offer a match, see IRA vs. 401(k): How to Choose for your game plan.)

How 401(k)s work

Because 401(k) plans are offered through an employer, a lot of the administrative hassle of setting up and managing the account is taken care of for you. But you do have to make a few key decisions along the way. Here’s what’s involved:

Set up your account through your employer.

Somewhere in that stack of paperwork (or PDFs or link to your employee benefits portal) your HR person handed you during your first week on the job are instructions on signing up for the company 401(k). You’ll be asked to indicate how much you want to contribute as either a percentage of your salary or a dollar amount. Your company’s payroll department takes care of the rest. Money is automatically taken out of your paycheck each pay period and deposited into your investment account. You can check on your savings and use any tools offered on your plan administrator’s website at any time.

Decide which type of 401(k) account you want to use.

Here we’re talking about traditional 401(k) vs. Roth 401(k), the difference being how contributions and withdrawals are taxed (or not taxed). (See more below under “Types of 401(k)s.”) Not all companies offer the Roth 401(k) option, which means a traditional 401(k) may be your only choice. But if you have access to both, know this: You can choose one, the other, or split your 401(k) contribution (50-50, 70-30, or however you want) between the two as long as your total combined contribution does not exceed the IRS’s maximum allowable amount.

Decide how much money you want to contribute.

Unlike traditional pension plans that are funded primarily by the company, 401(k)s are funded by the workers (though if your company has a match, they’re helping too). The IRS caps how much individuals are allowed to save in a 401(k) each year. For 2024, you can save up to $23,000 ($30,500 if you’re 50 or older). Any company match is not included in this amount. Some companies automatically enroll employees in the company 401(k) at a low percentage of salary (such as 3%) and incrementally increase contributions over time. Don’t assume you’re automatically enrolled once you start a new job. Look at your plan rules, and, if need be, adjust your contribution amount.

Quick Tip: How much should you contribute to your 401(k)?

There is no minimum you’re required to save in a 401(k), but at the very least, aim to contribute whatever it takes to receive the full company match (aka free money). If your financial circumstances change — you’re feeling flush after getting a bonus or need to tighten your belt to cover present-day expenses — you can adjust the amount you contribute throughout the year.

Choose your investments.

Getting money into a 401(k) is step one. Step two is getting that money invested so it grows to a handsome sum for your retirement, otherwise it may sit in cash and lose buying power to inflation. On your 401(k) website is a list of investment options offered to all plan participants. The average 401(k) plan offers 21 mutual funds, according to Plan Sponsor Council of America. That may sound like a lot, but the array is designed so that the majority of participants can find options that suit their time horizon and risk tolerance.

Once you indicate how you want your contributions invested, every subsequent deposit made into your 401(k) is automatically allocated proportionally into your choice(s). At any time you are free to change your investment choices within the options offered in your plan.

Quick Tip: One 401(k) investment that does it all

Overwhelmed by your investment choices? A simple option that’s a staple in many 401(k) plans is a target-date mutual fund. A target-date fund contains a mix of investments based on the investor’s planned retirement year. As time passes, the investment mix shifts to dial down exposure to risk. Target-date funds are intended as a one-stop shop: You choose one mutual fund based on your retirement year, and that fund does the rest.

Take it (or leave it) when you leave your job.

Any money you invest in your 401(k) is yours to keep, in addition to any vested matching contributions your employer made, even after you leave the company for a different job. At that point you can roll the money into an IRA at a brokerage of your choice, where your money can continue to be shielded from taxes until you start taking withdrawals in retirement in addition to having access to a larger choice of investments and more control over fees. (See more in What Is an IRA?)

You may also be allowed to leave your money in the 401(k), but be aware that as an ex-employee, you will no longer get any company match, and you may be asked to pick up the tab for plan administration fees. (See IRA vs. 401(k) for more on the pros and cons of each option.)

Types of 401(k)s

There are two main types of 401(k) plans: the traditional 401(k) and the Roth 401(k). Both offer tax breaks on the money you contribute from your salary into the account, and both shield investment growth within the plan from taxes. The difference between a traditional and Roth 401(k) is how and when the IRS collects taxes.

What is a traditional 401(k)?

A traditional 401(k) plan provides a break on income taxes for the year you make the contribution. Here’s how: Every dollar you contribute to a traditional 401(k) reduces your taxable income on a dollar-for-dollar basis. For example, if you make $75,000 a year and contribute $10,000 to your 401(k), your taxable income will drop to $65,000.

Investments within a traditional 401(k) grow on a tax-deferred basis. But eventually the IRS wants to be paid for all the taxes you avoided paying on contributions. That happens when you start making withdrawals in retirement. At that time you will owe income taxes on those distributions at whatever income tax rate you’re in.

The upfront tax break is what makes a traditional 401(k) a good choice for those in their prime earning years or those who expect their income to be lower in retirement. It allows you to take your tax break when you need it most, and defer the taxes owed to future years when you’re in a lower tax bracket.

What is a Roth 401(k)?

Roth 401(k)s are a newer entrant into the field of employer-sponsored retirement plans. As such, not all companies offer the Roth option in their 401(k) plans.

There is no upfront tax break on contributions to a Roth 401(k) like there is with the traditional 401(k). So, if you make $75,000 a year and contribute $10,000 to your Roth 401(k), you’ll still start off that tax year’s return showing $75,000 in taxable income. The extremely valuable tax benefit occurs when it comes time to withdraw the profits during retirement.

Unlike traditional 401(k)s, investments within a Roth 401(k) grow on a tax-free basis. Because you already paid income taxes on the money you contributed to the account, when you make withdrawals in retirement, you will owe nothing in taxes.

Tax-free withdrawals in retirement are what make a Roth 401(k) a good choice for young savers or those early in their careers. It allows you to take care of taxes now, while you’re in a relatively low tax bracket, and provides relief in the future when you’d be subject to a bigger income tax hit.

401(k) rules

There are some rules that apply to all 401(k) plans, regardless of where you work or what plan administrator your company uses. For example, the IRS dictates contribution limits and how contributions and withdrawals are taxed.

The differences in 401(k) rules come down to which plan features your company chooses to offer. Those include whether there’s a company match (how much it is, whether there’s a vesting schedule), what and how many investments are available, whether to offer a Roth 401(k) option, who pays the plan’s administrative fees, and whether to allow participant loans.

401(k) rules	Details
2024 contribution limits	$23,000 ($30,500 if you’re 50 or older)
How contributions are taxed	Traditional 401(k): Contributions lower your taxable income for the year on a dollar-for-dollar basis Roth 401(k): Contributions are included as part of your taxable income
How investment growth is taxed	Investment gains are untaxed while the money is in the account
How withdrawals are taxed	Traditional 401(k): Distributions taxed as ordinary income Roth 401(k): Distributions are not taxed
Roth option available	At employer’s discretion
Accessibility	Available only to employees of a company that offers a plan
Funded by	You; and employer if company offers matching contributions
Investment choices	Options selected by the plan administrator (primarily mutual funds)
Fees	Administrative fees may be passed on to participants or covered by employer
Requires minimum withdrawals starting the year you turn 73	Yes, unless you are still working at the company
Allows qualified withdrawals before age 59½ (income taxes and a 10% early withdrawal penalty may apply)	Some 401(k) plans allow withdrawals for hardships (e.g., medical, funeral, tuition/education, first-time home purchase expenses), but you may still owe a 10% early withdrawal penalty Allows early access to 55+ retirees
Loans from the account are allowed	Yes, if company plan rules allow it

Is your employer required to contribute to your 401(k) with a company match?

Show me!

Nope – it’s optional for employers to offer a match. However, many do! Nearly half of the plans managed by Vanguard in 2022 included a company match. All told, 95% of plans contributed to employees' 401(k) plans, either as a match or a straight-up deposit to their nest egg, according to Vanguard.

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The bottom line on 401(k)s

Despite the potential drawbacks (fees, limited investment choices), 401(k)s are a great retirement savings tool. As noted above, it behooves you to save at least enough to get any company match that’s offered. Otherwise you’re leaving free money on the table. Even if your company doesn’t supplement your savings, the high contribution limits offer a roomy parking spot for tax-advantaged savings.

A 401(k) is not your only savings option, however. You’re also allowed to save money in an IRA at the same time. We pit these two retirement savings stalwarts against each other in our IRA vs. 401(k) explainer, and map out a game plan on how to choose if you have limited retirement investment dollars at your disposal.

References

IRS’s Do’s and Don’ts of Hardship Distributions.

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About the Editorial Team

Dayana Yochim is a former Senior Writer/Editor at Reink Media Group who has written about personal finance and investing for more than 20 years. Her work has appeared in outlets including HerMoney.com, NerdWallet and the Motley Fool, and has been syndicated nationally. Dayana has also been a guest expert on "Today" and Good Morning America.

Carolyn Kimball is a former managing editor for StockBrokers.com and investor.com. Carolyn has more than 20 years of writing and editing experience at major media outlets including NerdWallet, the Los Angeles Times and the San Jose Mercury News. She specializes in coverage of personal financial products and services, wielding her editing skills to clarify complex (some might say befuddling) topics to help consumers make informed decisions about their money.

Andrea Coombes has 20+ years of experience helping people reach their financial goals. Her personal finance articles have appeared in the Wall Street Journal, USA Today, MarketWatch, Forbes, and other publications, and she's shared her expertise on CBS, NPR, "Marketplace," and more. She's been a financial coach and certified consumer credit counselor, and is working on becoming a Certified Financial Planner. She knows that owning pets isn't necessarily the best financial decision; her dog and two cats would argue this point.