How a 401(k) Works: Contributions, Limits, and Employer Matching

The Account Holding $7.4 Trillion in American Retirement Savings

As of the fourth quarter of 2023, Americans held approximately $7.4 trillion in 401(k) plans — the largest single pool of private retirement savings in the United States. Named for the subsection of the Internal Revenue Code that created it in 1978, the 401(k) transformed retirement planning by shifting responsibility from employers to individual workers. Today, roughly 70 million active participants across 625,000 plans depend on these accounts for their financial security in retirement.

How Contributions Work

A 401(k) is funded through payroll deferrals — the employee designates a percentage or flat dollar amount to be withheld from each paycheck before being deposited into the plan account. Traditional (pre-tax) deferrals reduce current taxable income; Roth deferrals do not reduce current income but grow tax-free.

2024 Contribution Limits

These limits apply per individual across all 401(k) plans. If someone works for two employers simultaneously, combined employee deferrals cannot exceed $23,000 total in 2024.

Employer Matching: Free Money with Conditions

Employer matching is the most valuable feature of most 401(k) plans. A common structure is a 50% match on employee contributions up to 6% of salary — meaning the employer contributes 3% of salary if the employee contributes at least 6%. A $70,000/year employee contributing 6% ($4,200) receives an additional $2,100 from the employer annually.

Match formulas vary widely:

• Dollar-for-dollar match up to a percentage — e.g., 100% match on first 3% of salary contributed.
• Partial match up to a percentage — e.g., 50% match on first 6% of salary (the most common structure per Vanguard's 2023 How America Saves report).
• Fixed percentage of salary — Employer contributes regardless of employee participation (a profit-sharing contribution).
• Tiered matches — e.g., 100% on first 3%, then 50% on next 2%.

Vesting Schedules

Employer contributions are not always immediately owned by the employee. Vesting schedules determine when employer contributions become non-forfeitable:

Employee contributions are always 100% immediately vested. An employee who leaves before full vesting forfeits unvested employer contributions — a significant consideration when evaluating job offers and departure timing.

Investment Options

401(k) plans offer a menu of investment options selected by the plan administrator, typically including:

• Target-date funds (automatically shift from equities to bonds as retirement approaches)
• Stock mutual funds (domestic large-cap, small-cap, international)
• Bond funds
• Stable value funds or money market options
• Company stock (subject to diversification rules and concentration risks)

Since 2012, the Department of Labor has required plan sponsors to disclose fees, making expense ratio comparison easier. Low-cost index funds have become the dominant choice in participant-directed plans.

Traditional vs. Roth 401(k)

Withdrawals and Penalties

Withdrawals from a traditional 401(k) are taxed as ordinary income. Early withdrawals (before age 59½) trigger a 10% penalty on top of income tax, with exceptions for separation from service after age 55, substantial equal periodic payments (72(t) distributions), disability, death, and qualified domestic relations orders (divorce).

At age 73, Required Minimum Distributions (RMDs) must begin for traditional 401(k) accounts. The penalty for missing an RMD is 25% of the amount that should have been withdrawn (reduced to 10% if corrected promptly under SECURE 2.0 rules).

Loans from a 401(k)

Most plans allow loans up to 50% of the vested balance or $50,000, whichever is less. The loan must be repaid within five years (longer for primary residence purchases). Interest is paid back to the participant's own account. If the participant leaves the employer before repaying the loan, the outstanding balance becomes a taxable distribution with applicable penalties — a significant risk for borrowers considering job changes.

This article is for informational purposes only and does not constitute financial advice.