A Basic Guide to Understanding the 401(k)

National 401(k) Day falls on the first Friday after Labor Day—this year, that’s September 5th. A 401(k) isn’t just another workplace benefit; it’s one of the most powerful tools you can use to build a secure and comfortable retirement. As a cornerstone of retirement savings in the U.S., your 401(k) can be the pathway to greater financial stability and peace of mind in your later years.

But what exactly is a 401(k)? How does it work? Why should you consider one? Whether you’re just starting your career, well into your working years, or approaching retirement, this guide will supply you with the knowledge you need to make informed decisions about your financial future.

***A huge THANK YOU to Brian Hodel at Parkside Financial Bank & Trust for contributing his expertise to this article!***

What is a 401(k) Retirement Plan?

The term “401(k)” gets thrown around a lot, but it’s not always clear what it really means. So, let’s break it down—what a 401(k) is, why it matters, and the different types of 401(k) plans you might come across.

Definition of a 401(k)

At its core, a 401(k) is an employer-sponsored retirement savings plan. You contribute part of your paycheck, choose how to invest it, and let it grow over time. What makes 401(k)s especially powerful are the tax advantages. Depending on whether you choose a Traditional or Roth 401(k), you’ll either reduce your taxable income today or enjoy tax-free withdrawals in retirement. On top of that, many employers sweeten the deal by matching employee contributions, giving your savings an extra boost.

Purpose of a 401(k)

The purpose of a 401(k) plan is to help you save money for your future, especially when you stop working. It’s like a treasure chest where you put a part of your paycheck every time you’re paid. Think of this money as a gift to your future self! Over time, those contributions grow into a nest egg that can give you greater security and freedom when it’s time to retire.

Types of 401(k) Plans

Traditional 401(k): Every dollar you put in this account reduces your current taxable income by the same amount. This makes it easier to save today because the net cost, for you, is lower than if you put money into a regular savings account. When you use the money in retirement, you’ll pay taxes on the withdrawals at that time. This strategy works well if you expect your tax rate to be lower in retirement than it is today.

Roth 401(k): Contributions to a Roth 401(k) don’t provide a tax break today—unlike a Traditional 401(k), they won’t reduce your current taxable income. However, the big advantage comes later: because you’ve already paid taxes on the money you put in, your withdrawals in retirement are tax-free (as long as the account is at least five years old and you’re over 59½). This strategy can be especially valuable if you expect your tax rate to be higher in the future than it is today.

Good to know: Most 401(k) plans let you contribute to both Traditional and Roth accounts. Since no one can predict future tax rates, splitting contributions between the two can be a smart strategy if your budget allows. However, this does not mean you will have two separate accounts. All of your savings are kept in one place, while the plan’s recordkeeper tracks how much you’ve contributed to each “bucket.” You can also adjust your contribution method over time, giving you the flexibility to choose what makes the most sense for you each year.

How does a 401(k) plan work?

Now that we’ve covered what a 401(k) is, let’s look at how it actually works. From eligibility and enrollment to accessing your money in retirement, this section will walk you through the key things to know.

Eligibility and Enrollment

Each employer sets their own rules for when you can join the plan. Usually, you’ll need to be employed at least three months (but no longer than a year) before becoming eligible. After you’re eligible, look for your enrollment date – it might be monthly, quarterly, or semi-annually. Once you’ve cleared these steps, you can jump into the plan whenever you’re ready! 

Contribution Options and Limits

Contributions are made automatically through payroll deductions. You’ll determine a percentage you’d like withheld each pay period and that money will be sent directly to your plan account. In 2025, the contribution limit is $23,500 for those under 50 and $31,000 for those 50 or older. Most people can’t hit those maximums, and that’s okay! A good starting point is contributing enough to earn the full employer match, if available. If there’s no match, or your budget is tight, consider starting at just 1% of your pay and increasing it by 1% each year.

Investment Choices Within the Plan

Your employer will determine what investment options you’ll have available to you once you begin saving your hard-earned income. Typically, they have hired outside experts to evaluate and monitor those options. Try not to let the task of picking investments intimidate you! The amount and consistency of your savings is far more important than picking the “right” investment. And most plans will have an investment choice that “Does It for You” such as a target date, balanced fund, or managed account. You can also ask your employer where to go for advice selecting the right investment for you. It’s common for 401(k) plan administrators to offer resources, tools, and educational materials to help you make informed decisions.

Vesting Rules

Vesting refers to ownership, or what percentage of the account balance is yours. 100% of the contributions you make to a plan are always yours! But sometimes employers will apply a vesting schedule to funds they contribute. This means you may have to work for the company for a set period of time in order to keep 100% of the contributions from your employer should you decide to leave. This schedule should be included in your plan documents, but be sure to ask questions if anything is unclear!

Withdrawal of Funds

Because 401(k)s are designed for retirement, you typically can’t withdraw funds until age 59½ without penalty. However, there are certain exceptions (like medical hardship) that allow earlier access to your funds. It’s important to understand that these withdrawals will often be subject to a 10% “early withdrawal” tax in addition to any ordinary income taxes you may owe. Some plans, but not all, allow you to take a loan from your account balance. While there is no automatic penalty, you must pay back the loan balance in full, along with interest, to avoid any potential penalties.

Bottom Line: Since these funds are earmarked for your retirement, it’s best to avoid tapping into them before 59 ½ unless you have no other options.

Why you should consider a 401(k)

Life has plenty of expenses—emergencies, education, vacations—but retirement savings often get pushed aside because the future feels far away. The truth is, there are no loans for retirement. And you may not always be able to keep earning income later in life. That’s why retirement saving is so critical! Starting with something, no matter how small, can make a huge difference. Now, let’s explore the advantages of a 401(k) specifically!

Consistent and Disciplined Savings

Because your contributions are made through payroll deductions, it’s much simpler to remain consistent! It’s like setting up a reliable automatic deposit for your future. By regularly funneling part of your paycheck to your 401(k), you cultivate a habit of saving that strengthens your financial foundation over time.

Employer Match

As mentioned above, employers often offer to contribute to your 401(k) plan as well. What better way to make saving for retirement easier than by having your employer cover a portion of your savings goals? Also, this ‘match’ is considered part of your total compensation package, so not taking advantage of it is leaving hard-earned money on the table! When possible, always make the most of any company matching contributions.

Tax Benefits

Whether you choose Traditional or Roth, you’re getting a valuable tax advantage that makes your money work harder. Plus, some savers may also qualify for the Saver’s Tax Credit, which directly reduces the amount of tax owed. The Savers Tax Credit, officially known as the Retirement Savings Contributions Credit, reduces your tax liability (the amount you owe) but cannot result in a refund beyond what you owe. You can qualify for this tax credit in 2025 if your adjusted gross income (AGI) is less than $76,500 for married couples filing jointly or less than $38,250 if you’re single or married filing separately. You can claim this when you file your tax returns using IRA form 8880: “Credit for Qualified Retirement Savings Contributions.”

Compound Growth

When you put money in your 401(k), it doesn’t just sit there. It grows because you’ve invested it! Your contributions earn returns, and then those returns earn returns—it’s a snowball effect. For example, using a 7% rate of return (a safe, historical average), every dollar saved in your 20s will grow to $16 in your 60s. If you are getting a dollar-for-dollar match from your employer, saving $1 today could equal $32 for you to spend in retirement!

This is important: If you feel behind on saving for retirement, don’t worry. It’s never too late to start! And the sooner you start with something, the better off you’ll be.

Remember, a 401(k) plan is not just a retirement account. It’s a powerful means to take charge of your financial future. It’s a promise to your future self that you’ll have the resources to live comfortably when you decide to leave the workforce.

As you consider your own financial path, keep in mind these key points:

• Start early: The sooner you begin saving in your 401(k), the more time your money has to grow through the magic of compounding interest.
• Contribute regularly: Consistent contributions, even small ones, can make a big difference over time. And when you can, increase your contributions!
• Take advantage of employer benefits: If your employer offers a match, take full advantage of it. It’s extra money to boost your retirement savings.
• Balance short-term needs with long-term goals: Saving for retirement doesn’t mean sacrificing all your current needs and desires. Find the right balance that works for you. If you are currently not saving anything for retirement, start with 1%. For someone making $50,000 per year, this breaks down to less than $10 per week.
• Explore tax benefits: Understand how your contributions can provide tax advantages, especially if you’re eligible for the Saver’s Tax Credit.
• Keep Learning: The world of finance and retirement planning is always evolving. Stay informed about your 401(k) and other financial options to make the best decisions for your future. Reach out to your employer for more information regarding your specific 401(k) plan.

While Prosperity Connection does not offer retirement planning services, there are still plenty of ways we can help! Our financial coaching services can help you build a budget that supports your retirement savings goal. We can also help you find the balance between those short-term needs and long-term goals mentioned above. Our coaches can even help you sift through recent financial statements to help you determine what questions to ask your HR team or 401(k) provider. Finally, we are always a great connection to valuable retirement planning resources! If you’re interested in learning how we might be able to help you, sign up for your first coaching session.