A 401(k) is an employer-sponsored retirement savings plan that lets employees contribute a portion of their pre-tax wages. The money is then invested and can grow over time. Employers may also match contributions up to a certain dollar amount or percentage.
There are two main types of 401(k) plans: traditional and Roth, each with different tax rules. 401(k) plans allow employees control over and responsibility for their retirement savings.
Let’s learn more about 401(k)s and how they work.
How 401(k) plans work
You typically sign up for a 401(k) through your employer and elect to contribute a portion of your pre-tax income to the account. Your employer may offer matching up to a certain percentage or amount. For example, they might match contributions up to 5% of your salary.
Employees can choose how to invest their contributions, often from a selection of mutual funds, stocks or bonds offered by the plan. Employees may also be able to choose target-date funds designed to limit risk as you get closer to retirement. The money in a 401(k) can grow tax-deferred until you withdraw it in retirement.
With traditional 401(k) plans, taxes are paid when the money is withdrawn during retirement. For Roth 401(k) plans, the taxes are paid upfront, and withdrawals during retirement are tax-free.
Contribution limits
There are limits to how much individuals and their employers can contribute to a 401(k) each year, known as contribution limits.
Contribution limits are reviewed and sometimes adjusted annually to keep pace with factors like inflation and the cost of living. The Internal Revenue Service (IRS) reviews these factors each year and may increase contribution limits to help ensure that employees can continue to save enough for retirement. Since these limits are updated annually, you may want to review and adjust your contributions accordingly to ensure you are making the most of your 401(k).
Employees over a certain age may be eligible for catch-up contributions, allowing them to contribute more than the standard contribution limit. This may help individuals nearing retirement save more and potentially reduce their pre-retirement tax burden.
For 2025, the employee contribution limit for a 401(k) is $23,500. There’s also a catch-up contribution of $7,500 for individuals aged 50 and over. Those aged 60-63 can benefit from an even larger catch-up contribution of $11,250 as of 2025.
For employees under 50, the limit for combined employee and employer contributions is 100% of the employee’s annual salary or $70,000 (whichever is lower) for 2025. This limit is $77,500 for employees 50 and older if you include catch-up contributions. The combined limit for employees 60-63 is $81,250.
Traditional 401(k) vs. Roth 401(k)
Both traditional 401(k) and Roth 401(k) plans are employer-sponsored retirement accounts that offer tax advantages, but they differ in how and when taxes are applied.
Each type offers different benefits based on your income, tax bracket and retirement goals.
Traditional 401(k)
Contributions to a traditional 401(k) are made with pre-tax dollars. This reduces your taxable income in the year you contribute. The funds grow tax-deferred, and you pay taxes on the withdrawals during retirement.
Traditional 401(k)s may make sense if you expect to be in a lower tax bracket in retirement or want to reduce your taxable income in the current year.
Here’s a look at the key benefits of a traditional 401(k):
- Contributions are made with pre-tax dollars
- Reduces taxable income in the year you contribute
- Money invested in the account grows tax-deferred
- No income limit to participate
- No taxes are paid on contributions or earnings until you withdraw money in retirement
Roth 401(k)
Contributions to a Roth 401(k) are made with after-tax dollars, so you don’t get an immediate tax break. Instead, you pay the taxes in the current year, but the money can grow tax-free. Withdrawals in retirement are also tax-free, as long as certain conditions are met.
Roth 401(k)s can make sense if you anticipate being in a higher tax bracket in retirement or if you’d prefer to take tax-free withdrawals in the future.
Let’s consider the key features of a Roth 401(k):
- Contributions are made with after-tax dollars
- No tax break on contributions, but investments can grow tax-free
- No income limits to participate
- Withdrawals in retirement are tax-free
Why contribute to your 401(k)?
Contributing to your 401(k) can be a valuable way to save for retirement. It may help to ensure you have funds set aside for the future, and the earlier you start, the more you could benefit. A 401(k) also offers a structured way to save for retirement through automated deductions, which can make it convenient to build your retirement savings over time.
Here are some benefits of contributing to your 401(k):
- Employer matching: Some employers match a dollar amount or percentage of your contributions, giving you extra money toward your retirement savings
- High contribution limits: The contribution limits for 401(k) accounts tend to be higher than for other retirement accounts, like IRAs. This can help grow your retirement savings faster.
- Growth potential: The money you contribute to your 401(k) is invested, so it has the potential to grow over time
- Tax benefits: A 401(k) account can reduce your taxable income in the current year or allow for tax-free withdrawals in retirement.
When can you withdraw from your 401(k)?
Generally, you can start withdrawing from your 401(k) without penalties once you reach the age of 59 1/2. Typically, you can take withdrawals as a lump sum, in installments or as periodic payments, depending on your plan’s rules.
You’ll typically need to pay taxes on any money you withdraw from a traditional 401(k), so it may make sense to space out withdrawals to have a manageable tax bill each year.
Withdrawals made before the age of 59 1/2 may be subject to a 10% early withdrawal tax penalty. There are some exceptions for early withdrawal without penalty, such as in cases of a qualifying disability, unreimbursed medical expenses, disaster recovery or if you separate from your employer during or after the year you turn 55 (or 50 for some employees).
Required minimum distributions
Starting at age 73, you must begin taking required minimum distributions (RMDs) annually from your 401(k).
RMDs are mandatory withdrawals. Starting in 2024, designated Roth accounts in 401(k) and 403(b) plans no longer require RMDs.
The amount of your RMD is based on your account balance and life expectancy. While you’re required to take the minimum amount, you can withdraw more if you wish. These withdrawals are generally taxable, except for any contributions made with after-tax dollars or qualified Roth distributions.
A 401(k) can be an effective way to save for retirement if your employer offers one. Before you sign up, be sure to understand how deductions will be taken from your paycheck and how that will impact your take-home pay.
Disclosure: This article is for general educational purposes. It is not intended to provide financial advice. It also is not intended to completely describe any Citi product or service. You should refer to the terms and conditions financial institutions provide for various products.
