How Does a 401(k) Plan Work?

As you know, healthcare and benefits can be complicated, which can make the enrollment process confusing. As part of that enrollment process, employers often offer fringe benefits like 401(k) plans. These retirement savings accounts are a cornerstone of employee benefits, providing an opportunity to plan for the future while reducing taxable income today.

So, what is a 401(k)? Here's what you need to know, including how contributions, employer matching, and tax implications work.

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings and investment account offered by employers that allows employees to contribute pre-tax income. The term comes from the section of the Internal Revenue Code that established and governs this type of retirement plan.

How Contributions Work

Contributions to a 401(k) plan are convenient, as the desired amount is deducted directly from each paycheck. Many employers also choose to contribute to their employees’ 401(k) accounts, either through matching contributions or other methods. However, the IRS sets annual limits on how much employers and employees can contribute, adjusting these limits for inflation each year. 

In 2025, the IRS has raised the 401(k) contribution limit to $23,500, allowing employees to set aside an additional $500 in their retirement accounts compared to the 2024 limit of $23,000. This increase follows a similar $500 jump from 2023 to 2024, reflecting the IRS’s ongoing adjustments for inflation.

Tax Advantages

401(k) funds are not tax-free but tax-deferred. Employees benefit upfront by lowering their taxable income, but they will eventually pay federal and state income taxes on funds they withdraw. Early withdrawals, made before age 59.5 (or 55 for retirees), often incur a 10% penalty on top of taxes. However, there are exceptions for financial hardship, such as medical or funeral expenses, depending on the plan.

How Does 401(k) Employer Matching Work? 

Employers are not required to contribute to employee 401(k)s, but many do as a way to attract and retain talent. Here are common methods of employer matching:

• Fixed Percentage Contributions: Employers contribute a set percentage of an employee’s salary, regardless of employee contributions.

• Matching Contributions: Employers match an employee’s contribution up to a certain percentage. For example, they may match 50 cents on the dollar for contributions up to 6% of an employee’s salary.

Matching contributions essentially add free money to an employee’s retirement savings. Financial advisors often recommend contributing enough to take full advantage of the employer’s match, if possible.

Advantages of a 401(k) Plan

For Employees

• Tax Benefits: Immediate reduction in taxable income for traditional 401(k) contributions.

• Employer Contributions: Boost retirement savings with little effort.

• Convenience: Automatic deductions from paychecks simplify saving.

For Employers

• Talent Attraction and Retention: A robust 401(k) plan can make an employer more appealing to job seekers.

• Tax Deductions: Employer contributions are generally tax-deductible.

• Increased Employee Satisfaction: Offering a 401(k) demonstrates investment in employees’ futures.

Common Misconceptions About 401(k)s

"It’s Too Late to Start Saving"

Even starting later in life can yield significant growth due to compound interest. Begin contributing as soon as possible to maximize your savings.

"My Savings Are Locked Away"

While early withdrawals often incur penalties, exceptions exist for hardship situations. Additionally, rollovers to other qualified accounts are penalty-free.

"Employer Matching Is Automatic"

Employees must usually contribute to their account to receive the full match, so be sure to review your plan’s terms.

Why 401(k) Plans Matter

A 401(k) plan is one of the most valuable benefits an employer can offer, providing both immediate and long-term financial advantages. Understanding how these plans work—from contributions to tax benefits and employer matching—is crucial for employees looking to maximize their retirement savings.

For small business HR leaders, offering a 401(k) can be a powerful tool to attract and retain top talent.

Additional Resources

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