A 401k is a retirement savings account offered through your employer. It’s one of the most powerful wealth-building tools available to working people — and most people underuse it because nobody ever clearly explained how it works. Here’s the plain-English version.
How a 401k works
You decide to contribute a percentage of your paycheck to your 401k — let’s say 6%. Every time you get paid, 6% is automatically moved from your paycheck into your 401k account before you even see it. That money gets invested in funds you choose (usually a mix of stock and bond funds), and it grows over time.
The big tax advantage: the money you contribute comes out of your paycheck before income taxes are calculated. If you earn $50,000 and contribute 6% ($3,000), you only pay income tax on $47,000 that year. You’re not taxed on that $3,000 until you withdraw it in retirement — by which point you may be in a lower tax bracket.
The employer match — free money you might be leaving on the table
Many employers match a portion of what you contribute. A common match is “50% of the first 6% you contribute” — meaning if you put in 6%, your employer adds another 3%. That’s an instant 50% return on that portion of your contribution before any investment growth happens.
If your employer offers a match and you’re not contributing enough to get the full match, you are leaving free money on the table. This is the single most important action in personal finance for anyone with a 401k available: contribute at least enough to get the full match.
How much should you contribute?
- Minimum: Enough to get the full employer match. Not doing this is like turning down part of your salary.
- Good target: 10–15% of your gross income total (including employer match).
- Maximum: The IRS limit is $23,500 in 2025 ($31,000 if you’re 50 or older). Very few people hit this, but it’s worth knowing.
If you can’t afford 10–15% right now, start with whatever you can — even 3% — and increase by 1% every time you get a raise. You’ll barely notice the difference each time, but it compounds significantly over years.
What to invest in inside your 401k
Most 401k plans offer a limited menu of funds. Look for these in order of preference:
- Total market index fund — tracks the entire US stock market. Look for the lowest expense ratio available.
- S&P 500 index fund — tracks the 500 largest US companies. Almost as good as total market.
- Target-date fund — automatically adjusts your investment mix as you approach retirement. If you don’t want to think about it, pick the one with your expected retirement year (e.g., “2060 Fund” if you plan to retire around 2060) and leave it alone.
Avoid funds with high expense ratios (above 0.5%). Over decades, a 1% expense ratio can cost you tens of thousands of dollars compared to a 0.05% index fund.
What happens to your 401k if you leave your job
Your money is yours — you keep it. You have three options:
- Leave it in your former employer’s plan — fine if the investment options are good
- Roll it over to your new employer’s 401k — keeps everything in one place
- Roll it over to an IRA — typically gives you the most investment options and control
Don’t cash it out. Early withdrawals before age 59½ come with a 10% penalty plus income taxes — you could lose 30–40% of the balance immediately.