What is a 401k and how does it work?

A 401(k) plan is an employer-sponsored retirement account that allows you to invest a portion of your income in stocks, bonds and other securities. Roughly 70 million Americans contribute to one according to a September 2023 report from the Investment Company Institute, totaling nearly $7 trillion in assets.

Contributing to a 401(k) is a great way to prepare for retirement: Because the money is automatically withdrawn from your paycheck, you won't be tempted to spend it before you retire. It's also tax-deferred, so there's more to invest now and, when you retire, you won't be bumped into a higher tax bracket.

In many cases, employers match some or all of their employees' contributions. However, the IRS sets limits on how much can be put into a 401(k) each year.

Below, CNBC Select explains what you need to know about 401(k) plans, including the different types, when you can start making withdrawals and more.

A traditional 401(k) plan is offered through an employer, with contributions taken directly from an employee's paycheck before any taxes are applied and invested in stocks, bonds and other asset classes.

You might need to sign up for your 401(k) plan, though a growing number of companies automatically enroll new employees. This encourages participation but it also means you have to specifically opt out if you don't want to contribute.

Contact your HR department to find out if your company offers a 401(k) plan, what kind and whether enrollment is automatic or not. Once your account has been created, review your asset allocation and make sure it aligns with your goals.

Most employers that offer 401(k) plans match their employees' contributions up to a certain amount. For example, you might put 10% of your paycheck in a 401(k), but your company may only match the first 6% of that contribution.

It may be a full dollar-to-dollar match or a partial match —  50 cents for every dollar you contribute, for example. It can also be a combination of the two, say, a full match up to 3% and then a 50% match for the next 2%.

Depending on your employer and plan, those matching contributions might not be 100% vested right away. In retirement planning, vesting refers to how much of the funds you own outright. Your contributions are always vested immediately but, depending on when your employer's matching funds vest, you might forfeit a percentage of them if you leave the plan or the company.

Full vesting can happen gradually, when it's known as "graded vesting," or all at once after a certain number of years, when it's called "cliff vesting. In 2022, close to 16% of employers required workers to wait six years before their matches vested 100%, according to the Plan Sponsor Council of America.

Some companies will offer non-matching contributions, which are made regardless of whether you contribute anything or not. 

While all 401(k) plans are employer-sponsored, there are several different kinds.

Traditional 401(k)

With a basic 401(k) plan, employees contribute a portion of their pre-tax wages into a retirement account. Their employer may match their contribution, either fully or partially, or make non-matching contributions. The taxes on contributions and any earnings are taken when withdrawals are made.

Roth 401(k)

Unlike a traditional 401(k), money is taxed before it's put into a Roth 401(k). While that means there's less to invest, you'll be able to withdraw it tax-free. That can be especially beneficial if you expect to be in a higher tax bracket when you retire. In addition, Roth 401(k) plans are not subject to required minimum distributions.

Safe harbor 401(k)

Employer contributions are required in safe harbor plans, whether or not the employee contributes. In addition, these plans are exempt from non-discrimination tests that ensure traditional 401(k) plans benefit all employees regardless of how much they earn. Employees with safe harbor plans are fully vested right away.

Simple 401(k)

A SIMPLE 401(k) is designed for businesses with 100 or fewer employees who receive at least $5,000 in compensation. Like safe harbor plans, they are exempt from nondiscrimination testing and employers must contribute even if a worker opts out.

The main difference from other plans is that no other employer-sponsored retirement options can be offered if workers are covered by a SIMPLE 401(k).

Solo 401(k)

If you are self-employed or run a small business with a spouse, you may be eligible for a solo 401(k) plan, also known as a one-participant plan. This allows you to enjoy the benefits of a retirement account without having an outside employer.

The IRS sets dollar limits on 401(k) contributions each year, which vary depending on the type of plan you have. In addition, workers 50 and older can make additional contributions, which also have annual caps.

For 2024, the limit for individual contributions to a traditional 401(k) is $23,000, while the cap on combined employee and employer contributions is $69,000. (If you're over 50, you can invest an additional $7,500 in in 2024.)

Overcontributing to your plan is possible, though rare — payroll departments and investment firms are on the lookout for it. If you do go over the limit, you'll have to withdraw the excess and pay taxes on it before Tax Day, according to the IRS.

If you fail to withdraw it by Tax Day, the overage will still be considered taxable income that year. And it will be taxed a second time when you finally make qualified distributions.

Experts recommend contributing at least as much to your 401(k) as your company is willing to match. If your employer match is 4% of your income, for example, you should contribute at least 4%.

Beyond that, you can work up to investing 15% of your income in your retirement account  (including any employer contribution), but it depends on your financial situation, age and retirement goals.

The average 401(k) balance at the end of 2023 was $118,600, according to Fidelity Investments, the largest provider of 401(k) plans in the U.S.

Similar to other retirement plans, such as the 403(b) and the Thrift Savings Plan, the IRS allows qualified distributions (penalty-free withdrawals) from 401(k) plans starting at age 59½.

If you make a withdrawal from a traditional 401(k) before then, you'll pay federal and state tax and a 10% penalty on it. (The IRS makes some exceptions for specific hardships, provided your specific plan allows it.)  If you make an early withdrawal on a Roth 401(k), you'll only pay the tax and penalty on any earnings.

Depending on your company, you may also be able to borrow money from your 401(k) without facing a penalty: A 401(k) loan can be for as much as 50% of your retirement savings, up to a maximum of $50,000.

Most seniors are required to start making annual withdrawals from their 401(k) plans starting at age 73. The amount of your required minimum distribution (RMD) depends on your age, marital status and how much you have in your retirement accounts.

Starting in 2024, Roth 401(k) accounts are no longer subject to RMDs.

If you leave a job where you were contributing to a 401(k), you have a few options. If the account has less than $7,000, your employer also has the right to cash out your account or roll it into an IRA.

Keep your old 401(k). If you're satisfied with your plan's investment options, leaving your money where it is an easy solution. You can also set up a separate 401(k) with your new employer.

Roll the balance into your new job's 401(k). If your new employer provides a 401(k) plan, you can typically move the funds from your old account into the new one without any penalty. This allows you to consolidate your funds and keep contributing more money.

Roll the balance into an IRA. This can give you a wider range of investing options and it's easier to make penalty-free early withdrawals if there is an emergency.

Cash out the balance. Your employer may allow you to liquidate your 401(k), but you will have to pay a 10% penalty, as well as applicable federal and state taxes. In addition, those funds can no longer be invested in a 401(k) plan and the money you take may bump you into a higher tax bracket.

If you've taken out a 401 (k) loan and left your job before you've fully paid it back, you may have to finish repaying quickly. If you default on a 401(k) loan, you'll owe both taxes and the 10% penalty.

401(k) plans and Individual Retirement Accounts (IRAs) are the two most common financial products for retirement planning, according to the U.S. Census Bureau. Many people have both, which can help diversify your portfolio and protect you from market fluctuations.

Both IRAs and 401(k) plans are typically tax-deferred but a 401(k) is offered through an employer, while you commonly open and fund an IRA yourself with the help of a bank or broker. The contribution cap on a 401(k) plan is much higher and you may even be able to borrow money from the account. But once you leave the employer who sponsored your plan, you can't contribute anymore.

In addition, investors usually have more investment options with an IRA. Fidelity is a good choice for beginners, with no account minimums or commissions on stock or ETF trades and many zero-fee index funds. New investors can also dip their toe in the pool with fractional shares available for as little as $1.

If you want to be hands-off with your IRA, Betterment offers automated trading, rebalancing and dividend reinvesting and allows customers to sync outside accounts. Betterment is one of our favorite robo-advisors, with multiple portfolio options, reasonable management fees and no minimum balance requirements.

Contributing to a 401(k) is one of the best ways to prepare for retirement. There are differences among plans, however, including particular tax advantages and employer contributions, so it's important to find out what type your company may offer.

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