How Does a 401(k) Work?
A 401(k) is an employer-sponsored retirement savings plan that allows you to contribute a portion of your pre-tax salary. Contributions reduce your taxable income for the year, and investment gains grow tax-deferred until withdrawal in retirement. Many employers also offer a matching contribution, which is essentially free money added to your account based on how much you contribute.
Understanding Employer Matching
A common employer match is 50% of your contributions up to 6% of salary. This means if you earn $75,000 and contribute 6% ($4,500), your employer adds $2,250 (50% of $4,500). If you only contribute 3%, you are leaving $1,125 of free money on the table. Always contribute at least enough to get the full employer match before directing savings elsewhere.
401(k) Contribution Limits
For 2024, the maximum employee contribution is $23,000, or $30,500 if you are age 50 or older (catch-up contribution of $7,500). Employer contributions do not count toward this limit, but the total of all contributions (employee + employer) cannot exceed $69,000 or $76,500 with catch-up contributions. These limits are adjusted annually for inflation.
Traditional vs Roth 401(k)
Traditional 401(k) contributions are pre-tax, reducing your current taxable income, but withdrawals in retirement are taxed as ordinary income. Roth 401(k) contributions are after-tax, meaning no upfront tax break, but qualified withdrawals in retirement are completely tax-free. If you expect to be in a higher tax bracket in retirement, Roth may be better. If you expect a lower bracket, traditional is usually more advantageous.
Frequently Asked Questions
How much should I contribute to my 401(k)?
At minimum, contribute enough to get the full employer match. Beyond that, financial experts recommend saving 15% of your income for retirement (including the employer match). If you cannot reach 15% immediately, start at the match level and increase by 1% each year until you reach your target.
What does employer match of 50% up to 6% mean?
It means your employer will contribute 50 cents for every dollar you put in, but only on contributions up to 6% of your salary. If you earn $80,000 and contribute 6% ($4,800), your employer adds $2,400 (50% of $4,800). Contributions above 6% receive no additional match. You need to contribute at least 6% to maximize the free money.
What is the maximum 401(k) contribution for 2024?
For 2024, the employee contribution limit is $23,000. If you are 50 or older, you can make an additional $7,500 in catch-up contributions, bringing the total to $30,500. The combined limit including employer contributions is $69,000 ($76,500 with catch-up). These limits typically increase each year with inflation.
Can I withdraw from my 401(k) before retirement?
Yes, but early withdrawals before age 59.5 typically incur a 10% penalty plus income tax on the amount withdrawn. Exceptions include hardship withdrawals (for certain emergencies), the Rule of 55 (if you leave your employer at 55 or later), and substantially equal periodic payments. Loans from your 401(k) are another option but must be repaid within 5 years.
Should I choose Traditional or Roth 401(k)?
Choose Traditional if you are in a high tax bracket now and expect a lower one in retirement. Choose Roth if you are in a lower bracket now and expect higher income later, or if you want tax-free withdrawals in retirement. Many financial advisors recommend splitting between both for tax diversification, giving you flexibility in retirement.