How does a 401k Retirement Plan Work?

Currently, 4 in 10 workers with a 401(k) don't actively contribute to their plans.¹ Some people may choose to not contribute due to financial stress and concerns about covering their current expenses. Others may not know what their options are or what type of plan their employers offer. Some people also just don't know enough about how a 401(k) works. Therefore, they don't understand the potential benefits of utilizing these retirement plans. Luckily, many employers offer a retirement savings plan that can help their employees prepare for the future. But how does a 401(k) work? Here, we'll go over everything you need to know regarding how 401(k) retirement plans work.

What is a 401(k)?

A 401(k) plan is an employer-sponsored retirement account that carries a number of tax advantages. However, you can only contribute if your employer offers a 401(k), typically part of the employee benefits package provided upon hiring. If you're not sure, check with your Human Resources department to see if you have an employer-sponsored retirement plan. Thanks to the SECURE 2.0 Act, many employers will be required to enroll their employees in 401(k) plans with an initial contribution limit between 3% and 10%, beginning in 2025, and employees that are automatically enrolled will have an opportunity their contributions.

In 2025, the IRS limits an employee's annual 401(k) contribution to $23,500. Many companies also offer an employer match to help their workforce save for retirement. The limit for contributions provided by your employer is an additional $46,500 (plus $7,500 for employees age 50 or older).

Although 401(k) plans are often a good way to save for retirement, it's important to understand your options. If you need a better understanding of your retirement savings plan options, it's best to work with a financial advisor or an HR expert within your organization for guidance.

It should be noted that self-employed or freelancers can also have a type of 401(k) called a self-employed 410(k) or a solo 401(k). As of 2025, with a solo 401(k), you can make yearly contributions as both the employee (up to $23,500) and the employer (up to 25% of eligible earnings) that total $70,000. People aged 50 and older can increase their contributions by $7,500 annually.

How Does a 401(k) Retirement Plan Work?

The money invested into your 401(k) plan will come directly from your paycheck. Once there, the investment can grow over the years. However, it's important to choose a plan that allows employees to start saving for retirement without causing financial strain on your business. Therefore, employers may want to consider both the type of plan they want to offer and whether they can provide an employer matching contribution

Types of 401(k) Plan Contribution

There are also several different types of 401(k) contributions, each offering unique pros and cons. The primary difference between them is how the tax benefits work. The two main types are traditional 401(k) plans and Roth 401(k) plans.

Traditional 401(k) Contribution

A traditional 401(k) plan contribution is a tax-advantaged retirement contribution in which the money is deducted from your paycheck before federal income taxes. This allows employees to reduce their annual taxable income, but that doesn't mean the money is never taxed. Instead, you pay taxes on your withdrawals in retirement. The income taxes will also apply to the accumulated growth of pre-tax contributions over the years. To avoid an early withdrawal penalty, you must wait to withdraw money until you are older than 59½.

Roth 401(k) Contribution

A Roth 401(k) plan is another type of 401(k) contribution. The contributions are made with after-tax dollars from your paycheck. Although you won't receive a tax deduction for the fiscal year the contributions were made, it allows your contribution to grow tax-free. Then, once you reach retirement age (59½), you can withdraw without paying additional taxes.

SIMPLE 401(k)

Small business owners sometimes have difficulty helping their employees reach retirement goals through traditional 401(k) plans, which is why the SIMPLE 401(k) was created. This is essentially a simplified version of a 401(k). However, the IRS does limit annual contributions more than traditional plans—the maximum employee contribution is $16,000 in 2024, with people 50 and over allowing an additional $3,5000 catch-up contribution.

Employers must also make a matching contribution to their employees' account (up to 3% of their pay) or nonelective contributions of 2% of each eligible employee's pay. You can find more information about SIMPLE 401(k) plans here.

What to Know About Employer Matching

When a company offers an employer match, they agree to contribute additional funds to the retirement account based on how much each employee contributes. Some common matching formula’s include a dollar-for-dollar match up to a certain percentage of your salary or a partial match (e.g., 50% of contributions) up to a limit.

For example, if your employer offers a 100% match on the first 5% of employee contributions, this means that if you contribute 5% of your salary to your 401(k), your employer will add a 5% contribution to your 401(k) account. Essentially, you're doubling the dollar amount going into your retirement account. Even if the match formula is less, such as 50% of your contributions, it’s still money your employer is contributing towards your retirement savings.

It’s important to check with your HR department to understand your company’s matching policy, as not all companies offer the same type or percentage of matching contributions. Some may have a vesting schedule, meaning you need to stay with the company for a certain number of years before you’re entitled to employer contributions. If your company offers matching contributions, it's wise to contribute at least enough to get the full match. Failing to do so is leaving potential money on the table.

What is 401(k) Vesting?

Regarding employer contributions in a 401(k), vesting is an important concept to understand. Vesting refers to the ownership of the funds your employer contributes to your retirement account. While the money you personally contribute to your 401(k) is always 100% vested and is yours, the money your employer contributes may be subject to a vesting schedule. Depending on the type of 401(k) you have and the plan your employer offers, you may be required to stay with the company for a certain amount of time before you can take ownership of any employer contributions. If you change jobs before you reach the end of the vesting schedule, your distribution may not include the full employer contributions.

Understanding 401(k) Investments

Once your contributions and any employer matching are deposited into your 401(k), the money doesn't just sit there—it’s invested. Typically, 401(k) plans offer a variety of investment options, including mutual funds, stocks, bonds and target-date funds. The specific choices available to you depend on your employer’s plan.

Most plans allow you to decide how your money is allocated among these investment options. Mutual funds are a common choice, as they pool money from many investors to buy a diversified mix of stocks and bonds. Stocks tend to offer higher potential returns be more volatile, while bonds may offer more stability but generally have lower returns. When deciding how to allocate your investments, it’s important to consider factors such as your financial goals, investment options, time horizon among other things.

It's generally best to seek professional guidance on your 401(k) investments. Alternatively, if you don’t want to actively manage your 401(k) investments, many plans offer target-date funds. These are designed to automatically adjust the allocation of stocks, bonds and other assets based on your estimated retirement year.

How Much Should You Contribute to Your 401(k)?

Deciding how much to contribute to your 401(k) depends on several factors, including your financial situation, retirement goals, and employer match.  Consider contributing enough to take full advantage of any employer match, if it works for you.

Beyond that, many financial experts suggest aiming to contribute 10% to 15% of your income towards retirement. If this seems like a stretch, start with a lower percentage and gradually increase it over time.

To help make retirement planning easier and more cost-effective, work with TriNet today. TriNet offers access to a multiple-employer retirement plan, which can give your company a competitive advantage while boosting employee retirement savings. We also offer comprehensive human capital consulting solutions to help you handle your toughest HR needs. Book a demo with us today to learn more.

© 2024 TriNet Group, Inc.  All rights reserved.  This communication is for informational purposes only, is not legal, tax or accounting advice, and is not an offer to sell, buy or procure insurance. TriNet is the single-employer sponsor of all its benefit plans, which does not include Enrich products and voluntary benefits that are not ERISA-covered group health insurance plans and enrollment is voluntary. Official plan documents always control and TriNet reserves the right to amend the benefit plans or change the offerings and deadlines.

This article may contain hyperlinks to websites operated by parties other than TriNet. Such hyperlinks are provided for reference only. TriNet does not control such web sites and is not responsible for their content. Inclusion of such hyperlinks in this article does not necessarily imply any endorsement of the material or association with their operators.