401(k)s: How They Work, and How They Can Bite
A 401(k) is an employer-sponsored retirement plan named for subsection 401(k) of the Internal
Revenue Code, created by the Revenue Act of 1978 (self-employed people can open a self-directed or
"solo" version). Contributions leave your paycheck pre-tax, and dividends, interest, and
capital gains inside the plan are tax-deferred — assets grow untaxed until withdrawal,
typically in retirement and a lower bracket. Employers may cap the share of pay you can defer and
may match your contributions up to a percentage of salary. The IRS deferral limit rises
with the cost of living: $23,500 for 2025 and $24,500 for 2026, with catch-ups to $32,500
at 50+ and $35,750 at ages 60–63, and a combined employee-plus-employer ceiling of $72,000 in 2026.
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The pros — and the cons
On the plus side: tax-deferred compounding; the employer match (in one survey, 43% of employees
said they'd trade pay for a richer match — it is, as the saying goes, free money); contributions
that are always tax-deductible because they reduce taxable income; limits far above an IRA's;
and strong creditor protection, which is precisely why raiding a 401(k) to dodge foreclosure or
debt is usually a mistake. On the minus side: a short menu of investment options chosen by the
employer; administrative fees that can run higher than a brokerage account's (mitigate with
low-cost index funds or ETFs); illiquidity before 59½; possible waiting periods before you may
even participate (six months is common, one year the legal max); and vesting — employer
money may become yours only gradually (graded: 25/50/75/100% over four years is typical) or all
at once (cliff), and leaving early forfeits the unvested part. Your own contributions are always
100% vested.
Defined contribution, defined benefit, and changing jobs
A 401(k) is a defined contribution plan: you choose the investments, and the outcome rides on
them. The older defined benefit pension promises a formula-based payout and rewards staying
25+ years with one employer — a career pattern that has largely vanished, which is why portable
401(k)s won. Changing jobs, you can usually leave the money in the old plan, roll it into the
new employer's plan, roll it into an IRA, or cash out and eat the taxes plus the 10% penalty
(rollovers are generally limited to one per twelve months). Inside most plans you'll find mutual
funds, index funds, ETFs, and target-date portfolios that de-risk automatically as retirement
nears; some plans allow a self-directed window or, after a rollover to an IRA, individual stocks.
Early withdrawals: hardship and the exceptions
Money out before 59½ is taxed as ordinary income and usually penalized 10% more. Some plans
allow hardship withdrawals — which cannot be repaid — for documented needs: unreimbursed
medical costs (or those above 7.5% of AGI), buying a principal residence, the next 12 months of
tuition, preventing foreclosure or eviction, funeral expenses, or repairing casualty damage to a
home. Other withdrawals escape the penalty without being "hardship" at all: death (paid to a
beneficiary), qualifying disability, leaving employment at 55 or older, amounts within the
medical-expense deduction, QDRO payments to a former spouse or dependent, and substantially
equal periodic payments under IRS rule 72(t). Calculator 2 prices all of it — and remember the
invisible cost beyond taxes and penalty: every dollar out is a dollar no longer compounding
tax-deferred.
Distributions, RMDs, solo and Roth variants
After 59½ you may take distributions — lump sum (simple, but one enormous tax year and no more
tax-deferred growth) or installments (flexible, but each year's amount must at least meet the
required minimum distribution once those apply) — or roll the plan into an IRA, convert it
to an annuity (including joint-and-survivor versions paying across two lifetimes), or simply do
nothing and let compounding run. Doing nothing ends at age 73, when RMDs begin: the prior
December 31 balance divided by an IRS life-expectancy factor, first deadline April 1 of the
following year, with a punitive tax on amounts not withdrawn (waivable in some cases by
withdrawing the shortfall promptly and filing Form 5329 with an explanation). One exception:
still working at 73 for the sponsoring employer, without owning 5%+ of the company, defers that
plan's RMDs until you actually retire. The solo 401(k) mirrors most of this for the
self-employed, adds a borrowing feature (typically up to 50% of the account or $50,000,
whichever is less), and — unusually — can hold real estate, tax liens, precious metals, or
foreign currency where the plan permits. The Roth 401(k) flips the tax timing: after-tax
contributions, tax-free qualified withdrawals, the same 2026 limits ($24,500 / $32,500 /
$35,750) shared with the traditional side — but contributions can't be withdrawn penalty-free
until the plan is five years old, and RMDs apply at 73 unless you roll it into a Roth IRA, which
has neither restriction.
FAQ
Should I contribute beyond the match?
Capture the full match first — nothing else reliably pays an instant 50–100%. Beyond that, compare the plan's fees and menu against an IRA's; many people fund the match, then an IRA, then come back to the 401(k) with what's left.
Why does contributing too much lose match money?
If your deferral percentage is so high that you reach the IRS annual limit in, say, October, your contributions stop — and in plans without a year-end true-up, so does the match for November and December. Spreading contributions across all twelve months (calculator 3's window) keeps every paycheck matched.
Disclaimer: These calculators provide estimates for educational purposes only and do not constitute financial
or tax advice. Contribution and match limits applied are the IRS 2026 figures ($24,500 / $32,500 at 50+ /
$35,750 at 60–63; $72,000 combined cap) and are not inflation-indexed in future projection years. Employer
match is modeled as the match % of your contribution, capped at the limit % of salary. Contributions are
credited at each year-end. Plan rules vary — confirm match, vesting, and true-up details with your plan
administrator.