401(k) Basics: What Is a 401(k), and How Does It Work?

Whether you want to retire to a quiet life on the beach or spend your golden years globetrotting to exotic locations, one thing is for sure: Retirement is likely to be the most expensive thing you will ever pay for.

And unlike other major life purchases (cars, homes, college) there are no loans for retirement. That means you'll have to save for it.

Enter the 401(k). It’s a special account that you can sign up for at work, if your employer offers one. And it’s designed specifically to help you save for retirement. Here’s the 101 on 401(k)s.

What Is a 401(k)?

A 401(k) is a retirement savings account that is sponsored by your employer. That means you can only contribute to a 401(k) if your work offers a plan. So, whenever you start a new job, check to see if it’s included in your benefits package. If it is, be sure to sign up and establish how much you want to contribute from your paycheck. Beginning in 2025, most employers will be required to auto enroll employees in a 401(k) plan with an initial contribution between three and 10 percent, thanks to updates to the SECURE 2.0 Act passed in 2022. Though even if you’re auto enrolled, you’ll want to adjust how much you contribute based on your situation.

Each employee is also responsible for choosing the investments within their 401(k) from the options provided by the 401(k) plan provider, although there is likely to be a default asset allocation set up initially. The investments you choose should depend on your risk tolerance, timeline to retirement and overall investing goals. More and more plans also offer something called target date funds, which are designed with your retirement timeline in mind. They might have riskier asset allocations to start, but become more conservative the closer you get to your target retirement date (hence the name).

A brief history of the 401(k)

Why is it called a 401(k)? Despite their popularity today, 401(k) plans were created almost by accident. It started when Congress passed the Revenue Act of 1978, which included a provision that was added to the Internal Revenue Code—Section 401(k)—that allowed employees to avoid being taxed on deferred compensation upfront

In 1980, benefits consultant Ted Benna referred to Section 401(k) while researching ways to design more tax-friendly retirement programs for a client. He came up with the idea to allow employees to save pre-tax money into a retirement plan while receiving an employer match. His client rejected the idea, so Benna’s own company, The Johnson Companies, became the first company to provide a 401(k) plan to its workers.

In 1981, the IRS issued new rules that allowed employees to fund their 401(k) through payroll deductions, which kickstarted the 401(k)’s popularity.

Then in 2001, the Economic Growth and Tax Relief Reconciliation Act changed the game for those age 50 and older by adding catch-up contributions. Starting in 2006, taxpayers could begin making after-tax qualified plan contributions to a Roth 401(k).

Access to a 401(k) became even easier when Congress overhauled the rules for saving for retirement in 2019. The SECURE Act aimed to make it easier for companies to offer a 401(k) and easier for employees to use them. The law extended the amount of time you’re able to contribute to a 401(k), made part-time employees eligible for a 401(k) and raised the age at which you’re required to take RMDs (among other things). The newest SECURE 2.0 legislation in 2023 included the requirement that new employees be automatically enrolled in a 401(k) or 403(b) plan with a rate of at least three to 10 percent of eligible wages.

How does a 401(k) work?

If your employer offers a 401(k) and you meet the eligibility requirements, you can enroll in the plan and begin making contributions via payroll. Before you start making contributions, though, you’ll need to decide:

• What type of 401(k) you want: Traditional or Roth (or you can have a mix of both)

• How much you want to save

• What you want to do with the money you save

401(k)s come in two distinct flavors: Traditional and Roth. Although at their heart they aim to achieve the same purpose—to encourage Americans to save more for retirement by offering tax incentives—they do this in drastically different ways. Here are the main ways they differ.

Traditional 401(k)

Your contributions are made before taxes and over the years your money grows tax-deferred. This means the contributions you make help lower your taxable income now, and you don’t pay any taxes on either your contributions or investment growth until you begin making withdrawals in retirement. At that point, the money you withdraw will be taxed as ordinary income.

Roth 401(k)

Your contributions are made after you've paid tax on the income, but your money grows tax-free. Because you already paid tax up front, when you withdraw money during retirement, you generally won’t have to pay taxes on the distributions.

Which one you choose will depend on a number of factors, including whether your company actually offers both (Roth 401(k)s are not as commonly offered as traditional 401(k)s) and whether you want a tax break now or later. It may be a good idea to do a mix of both to give yourself more options for how you withdraw money in retirement.

How to make contributions to a 401(k)

How much you decide to contribute to your 401(k) is really up to you, but there is a maximum amount that is set by the IRS each year. For 2023, the annual 401(k) contribution limit for workers 50 and younger is $22,500. Those 50 and older are allowed to add a “catch-up” contribution of $7,500 (which means they can contribute up to $30,000).

Apart from knowing the limits, other factors that’ll play into your contribution decision will include how much you think you’ll need to save for retirement, whether you’re saving for retirement through other types of accounts and how much you can actually afford to contribute each month.

Once you know how much you want to contribute, you’ll choose how much you want deducted from each paycheck that will go straight into your 401(k). This could be either a percentage of your pay or a specific dollar amount. Your human resources department will explain to you how to do this when informing you about your benefits.

Part of what makes 401(k)s such an easy way to save is the fact that contributions are automated. Some plans even allow you to automatically increase your contribution periodically, like every six months or every year, making it even easier to increase your contributions over time. Even if you don’t automatically increase your contributions, gradually raising your contribution amount is a great strategy for maximizing your savings.

401(k) employer match

As an added benefit, some employers offer to match some of the dollars you put into your 401(k) account, although with some parameters around how to become eligible for the match.

For example, your company might match 50 percent of what you contribute up to 6 percent of your income. That means if you make $50,000 a year and contribute 6 percent of your salary ($3,000) to your 401(k), your company will kick in another $1,500 on your behalf. It’s like free money for your retirement fund!

While how much you choose to contribute to your 401(k) will be specific to your situation, it’s a good idea to contribute at least what your employer will match—that way you’re maximizing your employer benefits.

How does a 401(k) pay out?

Beginning at age 59½, you’ll be eligible to begin withdrawing funds from your 401(k) without owing a 10 percent early withdrawal penalty.

Upon retirement, some people choose to take regular distributions, mirroring a steady paycheck, whereas some may choose take larger lump sums as needed. But chances are, your 401(k) will not be the only source of income you’ll have in retirement. A good retirement plan relies on multiple income streams from a variety of options, so you’re not relying solely on the success of a single financial vehicle.

How much you take out of your 401(k) (and when) will depend on how much you’ll get from Social Security, how you’ll pull from an IRA (if you have one) and how much you plan to access from other investments. Some people also supplement retirement income with cash value life insurance and nonqualified annuities, which when combined with investments in a 401(k) can help you add more certainty and lead to better financial outcomes in retirement. A financial advisor can help to design a strategy that optimizes how and when you withdraw your retirement savings.

Choosing your investments

Typically, a 401(k) plan offers different investment options or funds that will give you access to investments to help grow your money. Your 401(k) plan provider will have options for you to choose from, which might include specific types of mutual funds or “default” offerings based on your risk tolerance (i.e., how well you can stomach market swings).

Making the most of your 401(k)

If you’ve started putting money into your 401(k), congratulations! You already made it past the hardest part, which is getting started. But don’t just set it and forget it. You’ve also got to keep your money growing. These tips can help.

Commit to raising your contribution periodically

Even just raising your contribution by a small amount every six months or year can help, and it’s unlikely you’ll miss that amount from your paycheck, especially if you up your contribution whenever you get a raise. Some 401(k) plans even let you schedule an increase automatically.

Earmark portions of your raise or bonuses for retirement

If you receive a promotion that bumps your pay by, say, 5 percent, consider putting a portion of that towards your 401(k) contributions. Or if you’re expecting a big year-end bonus, consider sending some of that to your 401(k) for a one-time boost.

Work with a financial advisor

A Northwestern Mutual financial advisor can help you determine how much to save and take into account all the other savings you have in play. Your advisor can also show you options beyond your 401(k) and help you see how everything works together. As you get closer to retirement, an advisor can also help you make the most of your retirement savings by recommending tax-efficient strategies that capitalize on the perks that come with retirement savings accounts.

No investment strategy can guarantee a profit or protect against loss. All investing carries some risk, including loss of principal invested.

This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.