401(k) Basics: How It Works and How to Get the Full Match
How a 401(k) works, how employer matching and vesting work, and how to set up your plan the smart way.
If your employer offers a 401(k), it may be one of the most valuable benefits you have, especially if they match your contributions. Yet many people never sign up, or contribute too little to get the full match. This guide explains how a 401(k) works, how employer matching works, and how to set yours up the smart way.
401(k) plans are U.S. workplace retirement plans. Similar plans include the 403(b) for non-profits and schools and the 457(b) for some government workers. Annual contribution limits are set by the IRS and adjusted periodically, so check IRS.gov for current figures.
What is a 401(k)?
A 401(k) is a retirement savings account offered through your employer. You choose a percentage of each paycheck to contribute, and that money is invested in funds you select from the plan's menu. The two main versions are:
- Traditional 401(k): contributions come out of your paycheck before income tax, which lowers your taxable income today. You pay tax when you withdraw in retirement.
- Roth 401(k): contributions are made with after-tax money, and qualified withdrawals in retirement are tax-free.
Many plans offer both. The same "pay tax now or later" logic applies as with IRAs. See Roth IRA vs. traditional IRA.
How employer matching works
Many employers add money to your account based on how much you contribute. This is called a match, and it's essentially part of your compensation. Common formulas include:
- 50% match up to 6% of salary: if you contribute 6%, your employer adds 3%.
- 100% match up to 4% of salary: if you contribute 4%, your employer adds 4%.
Example
You earn $60,000 a year, and your employer matches 50% of contributions up to 6% of salary:
| You contribute | Your annual contribution | Employer match | Total going in |
|---|---|---|---|
| 0% | $0 | $0 | $0 |
| 3% | $1,800 | $900 | $2,700 |
| 6% | $3,600 | $1,800 | $5,400 |
Contributing less than 6% here means leaving free money on the table. That's why "get the full match" is one of the most common pieces of financial advice.
What is vesting?
Your own contributions are always 100% yours. But employer contributions may come with a vesting schedule, meaning you earn ownership of them over time. For example:
- Cliff vesting: you own 0% of the match until a set date (for example, three years), then 100%.
- Graded vesting: you gain ownership gradually, such as 20% per year.
If you leave before you're fully vested, you may forfeit some of the match. Your plan's Summary Plan Description explains the schedule.
How to set up your 401(k)
1. Enroll and pick a contribution rate
At minimum, contribute enough to get the full employer match. If you can, many guidelines suggest working toward saving 10–15% of your income for retirement in total, including the match.
2. Choose traditional, Roth or both
If you expect to be in a higher tax bracket later, Roth contributions may be attractive. If you want to lower your taxes now, traditional may be better. Splitting is a perfectly reasonable choice.
3. Choose your investments
Common options include:
- Target-date funds: an all-in-one fund that becomes more conservative as you approach the retirement year in its name. A simple, hands-off choice.
- Index funds: low-cost funds that track the market. See index funds for beginners.
Check each fund's expense ratio. Lower fees leave more money compounding for you.
4. Turn on automatic increases
Many plans let you automatically raise your contribution by 1% each year. You'll barely notice it, especially when timed with a raise.
5. Name your beneficiaries
Make sure your account has up-to-date beneficiaries. This often overrides what's written in a will.
Mistakes to avoid
- Not contributing enough to get the full match.
- Cashing out when you change jobs. This usually means taxes plus a 10% penalty if you're under 59½. Instead, consider leaving it, rolling it into your new employer's plan, or rolling it into an IRA.
- Borrowing from your 401(k) casually. Many plans allow loans, but if you leave your job, the balance may become due quickly or be treated as a withdrawal.
- Leaving money in cash or the default option without checking what it is.
- Panic selling during market drops.
Should you max out your 401(k)?
Once you've secured the match, it depends on your other priorities. Many people first build an emergency fund and pay off high-interest debt, then fund an IRA, then return to the 401(k) to contribute more. Use our compound interest calculator to see how increasing your contribution could grow over time.
Bottom line: Enroll, contribute at least enough to get the full employer match, pick low-cost diversified funds, and increase your contribution a little each year. Your future self will thank you.
Frequently asked questions
How much should I contribute to my 401(k)?
At minimum, contribute enough to get your employer's full match. Many guidelines suggest working toward saving 10 to 15% of your income for retirement in total, including the match.
What happens to my 401(k) if I change jobs?
It stays yours. You can usually leave it in the old plan, roll it into your new employer's plan or roll it into an IRA. Cashing out typically triggers taxes and possibly a penalty.
What is a 401(k) match?
It's money your employer adds to your account based on your contributions, such as 50 cents for every dollar you contribute up to 6% of your salary.
Should I choose a Roth 401(k) or traditional 401(k)?
Roth contributions may suit you if you expect a higher tax rate in retirement; traditional contributions lower your taxable income today. Splitting between both is a common approach.
Disclaimer: This article is for general educational purposes only and isn't personalised financial, tax or legal advice. Consider speaking with a qualified professional about your situation. Read our full disclaimer.