What is a 401k And How Does it Work?

The 401(k) has almost become synonymous with the working American. In fact, many people dream of landing a job that comes with a 401(k) benefit. But what is a 401(k) and how does it work?

The origin of the term “401(k)” is rooted in law. It comes from Section 401(k) of the U.S. Internal Revenue Code, introduced in 1978, which created this employer-sponsored retirement savings plan. A 401(k) allows employees to set aside a portion of their salary in investment options such as mutual funds, stocks, or bonds, which can grow on a tax-advantaged basis over time.

But is a 401(k) really such a powerful retirement tool?

Let’s find out

What is a 401(k) plan, and how does it work?

A 401(k) is a retirement savings plan offered by your employer. It lets you set aside a portion of your paycheck and invest it for the future. The 401(k) has one aim and one aim alone – to help you grow a retirement fund.

All other goals in life can be achieved through other means. You need money for college – you may get a scholarship or even a student loan. You need to buy a home or a car – you can apply for a mortgage or a loan. But retirement – it requires you to save and invest. There are no alternatives.

So, what does a 401(k) do? Well, 401(k)s offer several perks. Let’s highlight a few below:

One of the biggest ones is employer matching. Many employers match your contributions up to a certain percentage of your salary. So, while you are building your retirement fund, your employer is also helping you with some additional free money into your account.

The second prominent perk is the tax benefits. Before you understand these, you need to know that a 401(k) comes in two variants – traditional and Roth. With a traditional 401(k), you make contributions with pre-tax dollars. Before you are even taxed on your income, a portion of your salary is deferred into your 401(k) account. This helps lower your taxable income in the year you make the contribution. You can pay taxes later, when you withdraw the money in retirement. A Roth 401(k) allows you to contribute after-tax money. So, your salary is taxed before it is deposited into your 401(k). In this case, qualified withdrawals in retirement are generally tax-free.

Now, an important thing to note about a 401(k) is that it must be offered by your employer. If your employer does not provide one, you cannot use it. Employees can only contribute to a 401(k) if their workplace offers one. There is no option to open the account yourself. A 401(k) is built into your employment benefits. So, if you have access to one, use it to your advantage.

Starting in 2025, many employers will automatically enroll employees into a 401(k) plan under the SECURE 2.0 Act. But if you do not have one through your employer, try to look for jobs that offer a 401(k). Even though you can invest in other instruments and possibly find similar assets as the ones offered by a 401(k), like stocks, mutual funds, bonds, and others, you would not get employer contributions elsewhere.

Let’s move on to how a 401(k) works

A 401(k) invests your money in different types of investments. And you get to decide how it is invested, based on the options your employer’s plan offers. So, while your employer sets up the plan, you are responsible for choosing where your money goes.

Most 401(k) plans offer an array of investment options, usually including mutual funds, stocks, bonds, and Exchange Traded Funds (ETFs). Some plans also offer target-date funds. These funds are structured around a specific future retirement year. You pick the one closest to when you expect to retire, and the fund does the rest. Say you are 30 years old in 2026 and plan to retire at 60. In this case, you can select 2056. Early on, the fund will invest more aggressively to focus on growth. As you get closer to retirement, it gradually shifts to safer, more conservative investments.

You can also build your portfolio without relying on target-date funds. However, you should not just shoot in the dark. What you choose should depend on a few key things:

• Risk: How comfortable you are with ups and downs in the market
• Time horizon: How many years do you have until retirement
• Income: How much you earn in a year

So, say, you are just in your 30s. In this case, your retirement is likely decades away. Hence, you may be able to take more risks.

To know how a 401(k) works, you must understand contributions. Starting in 2025, many employers will automatically enroll employees into a 401(k) plan under the SECURE 2.0 Act. If you are eligible, you may be signed up without doing anything. The default contribution rate usually falls somewhere between 3% and 10% of your salary. But even if you are automatically enrolled, it pays to stay actively involved. 401(k) planning is a serious task. Taking charge of your 401(k) and, above all, working with a financial advisor, can help you make smarter 401k planning decisions and use your account more effectively.

How much can you contribute to a 401(k) each year?

Each year, the Internal Revenue Service (IRS) sets a cap on how much you can put into your 401(k), along with an overall limit that includes what your employer adds. The contribution limits for Roth 401(k)s are exactly the same as those for traditional 401(k)s. These limits change from time to time. Let’s take a look at the past year and this year:

For 2025, you can contribute up to $23,500 of your own money into your 401(k). If you are 50 or older, you may make an additional catch-up contribution of $7,500. And, if you are between the ages of 60 and 63, you can contribute up to an extra $11,250, as long as your plan allows it. In 2026, your standard employee contribution limit goes up to $24,500. If you are 50 or older, you can add a catch-up contribution of $8,000. And again, if you are between 60 and 63, you may be able to contribute up to $11,250 extra, depending on your employer’s plan rules.

An important detail to note is that employer matching does not count toward your personal contribution limit. So, the money your employer adds is on top of what you are allowed to put in yourself. When you combine employee contributions and employer contributions, the total limit is much higher. In 2025, the combined limit is $70,000. In 2026, it increases to $72,000.

Now, you may be wondering, what if you have more than one 401(k)?

Most people do.

If you change jobs mid-year or work for multiple employers over the years, you may have more than one 401(k). Some people switch to their new employer’s account, but many just let their old account be. Even if you have access to two or more 401(k) plans, the IRS will still implement the threshold of how much you can contribute in total. For example, in 2026, you can’t put more than $24,500 of your own money across all plans combined. You can split that amount between plans however you like, but you can’t exceed the limit.

How a 401(k) works in terms of penalties

A 401(k) has some rules in place – strict rules!

If you take money out before age 59½, the IRS imposes a penalty. In most cases, you will pay a 10% early withdrawal penalty, in addition to regular income tax. That said, it is not always black-and-white.

There are exceptions.

Certain situations, like large medical expenses, a permanent disability, etc., may allow you to access your 401(k) without the 10% penalty. But even then, income tax usually still applies. Once you cross age 59½, things get easier. You can withdraw money from your 401(k) without paying the 10% penalty. However, withdrawals from a traditional 401(k) are still taxed as ordinary income.

Now let’s fast-forward to your 70s. When you turn 73, the IRS requires you to start taking Required Minimum Distributions (RMDs) from your 401(k). You have to withdraw your money even if you do not need it. And if you forget or choose not to take your RMD, the IRS levies a penalty. The amount you must withdraw each year is based on two things: your account balance and your life expectancy, as determined by IRS tables.

401(k) planning tips that can help you maximize the potential of your account

Here’s how to use a 401(k) effectively to maximize its potential:

First things first, try to contribute as much as you reasonably can each year. Ideally, work your way up to the maximum limit. This way, you get the most out of any employer match, which is essentially free money. And, you unlock the full tax benefits that come with a 401(k). Even if maxing out feels unrealistic right now, start with at least enough to capture your employer’s full match.

Next, do not ignore your old 401(k)s. If you have changed jobs, there is a good chance you have money sitting in past plans that you have completely forgotten about. Consolidating your 401(k)s can make your life much easier. Fewer accounts help you stay more engaged with your investments. If you are rolling over old accounts, try to move them into the 401(k) or retirement account with the strongest investment choices.

Speaking of investments, take a moment to look inside your 401(k). Choose investments that align with your risk tolerance, time horizon, and goals. If your plan offers target-date funds, those can be a simple option. Also, know the rules. A 401(k) is meant for retirement, so try to leave your investments alone as much as you can. Early withdrawals can trigger penalties and taxes that eat into your savings fast.

And finally, the most important 401(k) planning tip of all – start as early as you can. Time is your biggest advantage. The longer your money stays invested, the more it benefits from compounding.

The bottom line on 401(k) planning

Understanding what a 401(k) is and how it works is important for every working professional in America. This retirement tool can be a strong ally in your long-term planning. It helps you prepare in advance, build retirement savings, and take advantage of tax benefits.

However, to make the most of your 401(k), it is wise to work with a financial advisor. An advisor can help you choose the right investment mix and ensure your account aligns with your retirement goals. You may explore our financial advisor directory to find an advisor near you in just a few easy steps.

Frequently Asked Questions (FAQs) about how a 401(k) works

1. What does a 401(k) do?

A 401(k) allows you to invest in different options so your money can grow on a tax-advantaged basis. It also offers employer-matching contributions and other benefits to help you plan for retirement.

2. Is a 401(k) the same as an Individual Retirement Account (IRA)?

No, a 401(k) and an IRA are different. While they offer some similar tax benefits, an IRA can be opened independently and does not include employer matching contributions. IRAs also have lower contribution limits compared to 401(k)s.

3. Is a 401(k) suitable for a 20-year-old?

Yes, a 401(k) is suitable for a 20-year-old just as much as it is for someone in their 30s, 40s, or 50s. In fact, starting early allows your investments more time to grow through compounding.

4. Can I switch jobs if I have a 401(k)?

Yes, you can switch jobs even if you have a 401(k). You can roll over your account to your new employer’s 401(k), transfer it to an IRA, or leave it with your previous employer. Having a 401(k) does not bind you to the same job. You can move your funds around and remain in full control of your retirement savings.

For additional information on retirement planning strategies tailored to your specific financial needs and goals, please visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm that manages private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services tailored to each client’s unique needs, providing institutional-caliber money management services based on a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.