401(k) plans: the basics

If your retirement is well down the road, you may be tempted to put off saving for something that seems far away. But the power of a 401(k) funded early is undeniable. You’ll benefit from tax-deferred growth, compound interest and, potentially, free money in the form of employer contributions, all helping you prepare for a comfortable and confident retirement.

Start by learning about the basics of a 401(k) plan and how you can use the account to support your retirement goals.

How a 401(k) plan works

Available through your employer, a 401(k) plan is a retirement savings vehicle that offers significant tax benefits to help you save for the future. Your pre-tax contributions are deducted from your pay and transferred to your 401(k) plan before income taxes are calculated on your wages. You don’t pay income taxes on the amount you contribute or on any investment gains until you withdraw money from the plan.

For example, if you earn $75,000 annually and contribute $3,500 to your employer-sponsored 401(k) on a pre-tax basis, your taxable employment income is now $71,500. Your federal and state taxes will be based on this figure instead. You’re not taxed on the $3,500 or its earnings until you take a distribution from the plan. 

Some 401(k) plans also allow you to make Roth contributions. These are made on an after-tax basis. They’re still deducted from your pay, but they’re transferred after taxes are calculated. While there’s no upfront tax benefit for Roth contributions, distributions from your Roth 401(k) account are free from federal income tax as long as the distribution is qualified.

You can make contributions to a 401(k) as soon as your employer allows. Many employers automatically enroll you once you become eligible. If this is the case, check that the default contribution rate and investment selections are right for you.

Most 401(k) plans let you choose how to invest the money in your account from a list of options. You’ll want to consult with your advisor to determine the best choice for your retirement goals.

Contribution limits

In 2025, you can contribute up to $23,500 to a 401(k) plan. Savers who are 50 or older can contribute more: $31,000 for those 50-59 or 64 and older, and $34,750 for those 60-63. If your plan allows Roth contributions, you can split your total annual contribution between pre-tax and Roth any way you’d like.

If you contribute to another employer’s 401(k), 403(b), SIMPLE or SAR-SEP plan, your total contributions to all of these plans – both pre-tax and Roth – cannot exceed the annual limit.

Your participation in an employer-sponsored plan can impact your ability to make a tax-deductible contribution to a traditional IRA. Deductible contributions are phased out based on your modified adjusted gross income and your filing status. For example, a married couple filing jointly with modified adjusted gross income of less than $126,000 can deduct the maximum of $7,000, $8,000 if they are both 50 and over, if they have at least that much in earned income. But a couple with modified adjusted gross income of $236,000 to $246,000 cannot deduct the full amount and above $246,00 cannot deduct any amount of their contribution.

One of the benefits of contributing to an employer-sponsored 401(k) plan is that employers often offer to match employee contributions up to a certain amount. Try contributing as much as possible to get the maximum matching contribution from your employer, as this is essentially free money.

Understanding qualified distributions

Before making any withdrawals from your 401(k), you should understand the tax ramifications.

Withdrawals from pre-tax 401(k) accounts are subject to tax plus a 10% penalty unless you meet an exception such as disability, separation at 55 rule, or having an age of at least 59.5.  Distributions are not subject to penalty after you turn 59.5 or meet another exception.

A distribution from a Roth 401(k) is comprised of a proportionate amount of contributions and earnings, and must be “qualified” to be tax-free. A qualified distribution is one in which a five-year holding period is met and the account holder is either 59.5, deceased or disabled. If the distribution is not qualified, the earnings portion of the distribution is subject to tax and a 10% penalty if no exception is met. The five-year holding period starts on January 1 of the year in which you make your first Roth contribution. If you made your first Roth contribution in November 2024, your five-year waiting period began January 1, 2024, and ends on December 31, 2028.

What if I leave my job?

When you leave a job where you were contributing to a 401(k), you can generally leave your money in your 401(k) plan.

While your contributions and associated earnings are always completely vested, the plan may require up to six years of service before you’re fully vested in employer matching contributions and associated earnings. If you terminate employment before being vested, you may forfeit employer contributions and associated earnings.

Your plan may cash you out when you leave your job if your vested balance is below a certain threshold. The plan may roll your funds into an IRA established on your behalf unless you elect to receive your balance in cash.

You can roll all or part of your 401(k) into an IRA. Pre-tax contributions map to a traditional IRA and Roth contributions to a Roth IRA. Often used as a tax strategy, you can convert non-Roth dollars to a Roth IRA, but income taxes will apply to any tax-deferred amounts in the year of the conversion.

If your new employer offers a retirement plan that accepts rollovers, you may also transfer your funds there.

Of course, you may be able to take a cash distribution of your account, but keep in mind that a distribution may be subject to income tax and a possible 10% penalty tax if you’re under age 59 1/2, unless an exception applies. Be sure to consider all of your available options and the applicable fees and features of each option before moving your retirement assets.

A 401(k) plan is a useful retirement saving tool that can help you achieve the retirement you desire. Starting early will set you up for success and allow your investment to grow effectively.

This material has been created by Raymond James for use by its financial advisors.

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation.

401(k) plans are long-term retirement savings vehicles. Withdrawal of pre-tax contributions and/or earnings will be subject to ordinary income tax and, if taken prior to age 59 1/2, may be subject to a 10% federal tax penalty.

Matching contributions from your employer may be subject to a vesting schedule. Please consult with your financial advisor for more information.

Roth 401(k) plans are long-term retirement savings vehicles. Contributions to a Roth 401(k) are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Unlike Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 72 (70 ½ if you reach 70 ½ before January 1, 2020).