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

A 401(k) is a tax-advantaged retirement savings plan offered by employers that allows workers to set aside a portion of their income, typically before taxes are applied. Named after the section of the Internal Revenue Code that governs it, a 401(k) is one of the most widely used retirement savings options available to American workers. ^[1]

In this article, we’ll discuss how 401(k) plans work, why they are beneficial, and how many people use them to plan their financial futures.

Key points

• A 401(k) is an employer-sponsored retirement savings plan that allows workers to contribute a portion of their salary, either pre-tax (traditional) or after-tax (Roth), up to an annual IRS limit of $24,500 in 2026.
• As of September 2025, around 70 million Americans actively participate in 401(k) plans, though access is not universal; BLS data from March 2025 shows that only 70% of private industry workers had access to a defined contribution plan.
• While both 401(k)s and IRAs are tax-advantaged retirement savings options, key differences include contribution limits, who sets up the account, whether employer contributions are available, and investment flexibility.

How does a 401(k) work?

A 401(k) is funded primarily through employee salary deferrals. This means a percentage of each paycheck is redirected into the 401(k) account before it reaches the employee, depending on whether contributions are traditional (pre-tax) or Roth (after-tax). Employees choose how much they wish to contribute, typically expressed as a percentage of their salary, up to annual limits set by the Internal Revenue Service (IRS).

401(k) annual contribution limits

For 2026, the IRS set the employee contribution limit at $24,500, subject to cost-of-living adjustments. Employees aged 50 or over are permitted to make catch-up contributions at the end of the calendar year. As of 2026, they can make additional elective salary deferrals of:

• $8,000 to traditional safe harbor 401(k) plans. Employees aged 60, 61, 62, or 63 who participate in these plans have a higher catch-up contribution limit of $11,250 due to a change made under the SECURE 2.0 Act.
• $4,000 to SIMPLE 401(k) plans. Employees aged 60, 61, 62, or 63 who participate in these plans have a higher catch-up contribution limit of $5,250 due to a change made under the SECURE 2.0 Act.

Be aware that these catch-up contribution amounts are subject to cost-of-living adjustments. You don’t need to be “behind” in your plan contributions in order to make these additional elective deferrals.^[2]
Employee contributions must be made within the calendar year, unlike IRA contributions, which can be made up to the tax filing deadline of the following year.^[3]

Traditional 401(k) vs Roth 401(k)

Most 401(k) plans offer two contribution types. Here’s how the two options differ:

• Traditional 401(k) - Contributions are made pre-tax, reducing taxable income in the year they are made, and withdrawals in retirement are taxed as ordinary income.
• Roth 401(k) - Contributions come from after-tax income, so qualifying withdrawals in retirement are tax-free. ^[3]

Withdrawing from a 401(k)

If you have a traditional 401(k) plan, when you reach retirement age, your withdrawals will be taxed as regular income. If you have a Roth 401(k) plan, your withdrawals in retirement will not be taxed.

Distributions taken before age 59.5 are generally subject to an additional 10% early withdrawal tax on top of regular income tax, unless a qualifying exception applies. ^[4]

Required minimum distributions (RMD)

Account holders must begin taking Required Minimum Distributions (RMDs) at age 73. Most workplace plan participants can delay this until the year they retire, if later. Failure to take the required amount may result in an excise tax of 25% on the shortfall, reduced to 10% if corrected within two years. Roth 401(k) accounts are not subject to RMDs during the account owner's lifetime.^[5]

How many Americans have a 401(k)?

There are around 70 million active participants in 401(k) plans in the U.S. across around 730,000 plans as of September 2025, in addition to millions of retirees who hold assets in these accounts. ^[6]

Data from the Investment Company Institute from Q3 2025 shows that Americans held $10 trillion in 401(k) plans. This makes up 71.9% of the $13.9 trillion held in all employer-based defined contribution retirement plans. ^[7]

Access to retirement savings plans

It’s important to note that 401(k)s and similar retirement plans are not available to everyone. According to data from the Bureau of Labor Statistics (BLS) as of March 2025, retirement benefits were available to 72% of private industry workers. Of these workers, 70% had access to defined contribution plans, and 14% had access to defined benefit plans.

Access also varies by establishment size; typically, the bigger the establishment, the better the access to retirement plans. In private industry establishments with fewer than 100 workers, 59% had access to retirement benefits, while 90% of workers in establishments of 500 workers or more had access to these benefits. ^[8]

If you’re applying for a new job, it’s a good idea to find out about the retirement savings options available to you so you’re well-informed before accepting the job.

What is the difference between a 401(k) and an IRA?

While 401(k) plans and Individual Retirement Accounts (IRAs) are both types of retirement savings plans, there are some key differences between the two.

Source ^[9]

What happens to a 401(k) if you switch jobs?

If you leave a job while enrolled in a 401(k) retirement plan, what happens to it will depend on the vested balance you have in your account at the time you leave. Vesting is a process in which your employer’s contributions to the account gradually become yours over time. For example, you might take ownership of 20% of your employer’s contributions each year up until five years, when you own it all outright. If you left after three years, you’d only own 60% of your employer’s contributions.

Your vested balance is a combination of your own contributions (which are always vested) and the percentage of your employer’s contributions that you own at the time you leave. ^[10]

If you have less than $7,000 vested

If you have less than $1,000 vested in your account when you leave, your old employer can cash out the account or roll it into an IRA. If your vested balance is between $1,000 and $7,000, in some cases, your old employer might be able to automatically roll it over to your new employer’s retirement plan. ^[10]

If you have more than $7,000 vested

If you have at least $7,000 vested in your 401(k), you have a few options when you leave a job:

• Leave your savings with your former employer — if the plan allows it, your money will continue to grow tax-deferred, but you won't be able to make additional contributions. Check whether the plan requires a distribution at any point in the future.
• Roll over into an IRA — moving your savings into an IRA may give you a wider range of investment options than your employer's plan, and you can continue contributing as long as you have earned income.
• Move your savings to a new employer's plan — if your new employer accepts rollovers, consolidating into a single plan can make managing your retirement savings easier. A direct rollover, where funds are transferred directly between providers, is the simplest way to do this and avoids tax withholding complications.
• Withdraw the money as cash — while this is an option, withdrawals are subject to income tax and early withdrawal penalties, making it the most costly choice for most people. ^[10]

Bottom line

A 401(k) is one of the most widely used retirement savings tools available to American workers, offering tax advantages and, in many cases, employer contributions that can help build long-term financial security. Understanding how contributions work, what your withdrawal options are, and how a 401(k) compares to other retirement savings accounts like an IRA can help you make more informed decisions about your retirement planning.

Sources

1. Fidelity, “What is a 401(k)?” https://www.fidelity.com/learning-center/smart-money/what-is-a-401k Accessed February 26, 2026
2. IRS, “Retirement Topics - 401(k)” https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits Accessed February 26, 2026
3. IRS, “401(k) Plan Overview” https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview Accessed February 26, 2026
4. IRS, “Topic no. 558, Additional tax on early distributions from retirement plans other than IRAs” https://www.irs.gov/taxtopics/tc558 Accessed February 26, 2026
5. IRS, “Retirement plan and IRA minimum distribution FAQs” https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs Accessed February 26, 2026
6. ICI, “401(k)” https://www.ici.org/resource-hubs/401k Accessed February 26, 2026
7. ICI, “Release: Quarterly Retirement Market Data, Third Quarter 2025” https://www.ici.org/statistical-report/ret_25_q3 Accessed February 26, 2026
8. BLS, “Employee Benefits in the United States Summary” https://www.bls.gov/news.release/ebs2.nr0.htm Accessed February 26, 2026
9. IRS, “Types of retirement plans” https://www.irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans Accessed February 26, 2026
10. Fidelity, “What happens to your 401(k) when you leave a job?” https://www.fidelity.com/learning-center/smart-money/what-happens-to-your-401k-when-you-leave-a-job Accessed February 26, 2026

About the author

Becca has over 10 years of experience as a content writer, working across various industries including finance, digital marketing, education, travel, and technology. Her work has been featured in publications including Forbes, Business Insider, AOL, Yahoo, GOBankingRates, and more.

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