How a 401(k) plan works: contributions, taxes, and employer matching

Executive overview

A 401(k) is an employer-offered retirement account funded with pre-tax payroll deductions. Contributions reduce taxable income now but are taxed on withdrawal — making them tax-deferred, not tax-free. Early withdrawals before age 59.5 (or 55 for retirees) trigger a 10% penalty on top of income tax.

Employer matching is essentially free money — contribute at least enough to capture the full match.

Key rules and limits

• IRS caps total annual contributions and adjusts the limit for inflation each year
• Funds are tax-deferred: income tax is owed on withdrawals, not contributions
• Early withdrawal penalty: 10% plus income tax
• Penalty-free withdrawal age: 59.5 for working employees, 55 for retirees
• Some employers allow hardship exceptions (e.g. medical or funeral costs)

Employer matching

• Employers are not required to contribute, but many do
• Common structures: fixed percentage of salary, or 50-cent match per dollar up to a set percentage
• Example: employer matches 3% of salary, or 50% of contributions up to 6% of salary
• Many employers require a waiting period (e.g. one year) before contributing
• Larger employers may auto-enroll new hires; smaller ones often don't