Planning for retirement is a crucial aspect of financial health, and understanding the different options available is key to making informed decisions. One such option is the 401(k) retirement savings plan.

Together, we’ll discuss how a 401(k) works, why it's essential for your future, and how much you should contribute. We'll also explore how your contributions can impact your overall financial health and how a 401(k) can help encourage responsible spending.

What is a 401(k)?

A 401(k) is an employer-sponsored retirement plan that allows employees to enroll in order to save a portion of their income for their future retirement. Named after the section of the Internal Revenue Code that governs them, these plans are designed to incentivize long-term savings by offering tax benefits and sometimes matching contributions from employers.

You can still use a 401(k) if you’re self-employed — however, you’d have to pay any fees associated with the account and find your own plan provider.

How does a 401(k) work?

This plan works by letting employees divert a portion of their paycheck into the plan, which is then invested in a variety of investment options. These options often include mutual funds focused on stocks, bonds, and money market investments — some plans may even offer target-date funds or other managed funds.

The good news is that you don’t need to manage your investments yourself. Most 401(k)s have dedicated financial managers that invest your money on your behalf based on your preferences.

Often, you can just let the plan administrator know how comfortable you are with risk and what your retirement goals are, and they’ll come up with investment strategies that fit your needs.

Plus, many employers offer what's known as an employer match. This means that for every dollar you contribute up to a certain percentage of your salary, your employer would match that contribution in your 401(k) account. This matching contribution is part of your total compensation package, similar to insurance and paid vacation.

If you have a 401(k) through your employer, it’s important to learn whether or not you have a vesting period. Your company’s vesting schedule determines how long you need to be employed at the company in order to keep the full match benefits. If you leave your job before your vesting period is up, your employer may take back their contributions.

Roth 401(k) vs. traditional 401(k): What's the difference?

Choosing between a Roth 401(k) and a traditional 401(k) for your retirement savings is a significant decision, and it comes down to how taxes work with these types of plans.

While the right choice for you can hinge on many different factors, it’s important to remember that you can actually split your contributions between the two. This way, you can tailor your financial strategy to your own needs and goals.

If you’re unsure which way to go or how to split your contributions, you can always seek out investment advice from a financial advisor.

Roth IRA

Contributions to a Roth 401(k) or a Roth individual retirement account (IRA) are made with after-tax dollars, meaning you've already paid income tax on the money you contribute. The advantage here is that your withdrawals in retirement, including both contributions and earnings, are generally tax-free. This can be particularly helpful if you anticipate being in a higher tax bracket when you retire.

Traditional 401(k)

Contributions to a traditional 401(k) are made with pre-tax dollars, which means they reduce your taxable income in the year you make them. Additionally, the money in a 401(k) grows tax-deferred, meaning you won't pay taxes on the investment earnings until you request qualified distributions in retirement. At this point, the distributions will count as ordinary income and will be taxed accordingly.

Over the long term, this enables your savings to grow more quickly than they might in a taxable account. However, since the money will grow in your account and taxes are often based on percentages, you’ll also pay more in tax when you do make a withdrawal.

Can you withdraw from your 401(k) before you retire?

While a 401(k) is designed to be a retirement savings vehicle, life can sometimes throw unexpected financial curveballs. If you find yourself in a situation where you need to access the funds in your 401(k) before reaching the age of 59½, it's important to understand the consequences.

Early withdrawal penalties

Withdrawing from your 401(k) before the age of 59½ typically results in a penalty of 10% on the amount you’ve withdrawn. This is in addition to the regular income tax you'll owe on the distribution (as this money will be counted toward your taxable income for the year). It's a significant financial hit that can erode your savings.

Loss of tax advantages

One of the key benefits of a traditional 401(k) is the tax-deferred growth of your investments. Making an early withdrawal can interrupt this tax-advantaged growth, potentially leaving you with less in retirement.

Reduced retirement savings

Every dollar you withdraw early is a dollar that won't be available for your retirement. It's important to consider the long-term impact this can have on your financial security.

Alternative options

Before tapping into your 401(k) prematurely, explore alternative sources of funds, such as emergency savings, personal loans, credit cards you can pay off without carrying a balance, or other financial resources that won't jeopardize your retirement savings.

Depending on your 401(k) plan, you may even be able to take out a loan from your retirement account. This is one way to access the funds in your savings without experiencing the consequences of early withdrawals. However, you will have to repay this loan according to the payment plan you agreed to, and you’ll often have to pay interest on the original amount. In many ways, it’s just like managing a regular personal loan.

If you’re simply looking to move your savings over to a new employer’s plan, you can submit a rollover request. This can help you move your entire account balance over to a new investment account without encountering penalties.

How much should you contribute to your 401(k)?

How much you contribute to your 401(k) can significantly influence your financial comfort in retirement. This decision is personal and varies based on individual financial situations, lifestyle needs, retirement goals, and whether or not you have an employer matching contributions.

A common starting point is contributing enough to take full advantage of your employer's contributions, if available. If your employer offers a dollar-for-dollar match up to, say, 5% of your salary, you may want to contribute at least that much. This first step can instantly double your investment, providing a return that's hard to beat with other investments.

Beyond hitting the employer match, a widely endorsed rule of thumb is to aim to save between 10% and 15% of your pre-tax income for retirement. This includes your 401(k) contributions and other retirement savings, such as IRAs. If you started saving for retirement later in life, you may need to make higher employee contributions to catch up.

It’s important to note here that there are also annual contribution limits, which dictate the maximum amount you can contribute. These change year to year based on the current economy, so it’s wise to stay up-to-date on this limit.

If you’re 50 or older, you can also make special catch-up contributions. These allow you to go over your contribution limit in order to meet your retirement goals, although there are special rules to follow to make sure your contributions are in line with current regulations.

Your income level can also influence your 401(k) contributions. If you're in a higher income bracket, you might be able to contribute more without significantly impacting your current lifestyle. Conversely, if you're in a lower income bracket, contributing a substantial portion of your income might not be feasible. The important thing to remember here is to contribute what you can — every little bit will add up over time.

Lastly, consider seeking advice from a financial advisor. They can provide personalized guidance based on your specific financial situation and retirement goals. They can also help you navigate the complexities of retirement planning, considering factors like your current age, desired retirement age, projected expenses in retirement, and other sources of retirement income.

The bottom line

We've explored how a 401(k) works, the benefits it provides, and how much to contribute. Your 401(k) is more than just a retirement account — it's a vehicle that empowers responsible financial planning, rewarding you with tax advantages and the potential for substantial growth.

Saving your money in a 401(k) can help set you up for a prosperous retirement. Your financial future is worth the investment, and a well-managed 401(k) is a key element in that journey to financial security and peace of mind.

Investing into your 401(k) is just one piece of the financial puzzle. It’s equally important to monitor your credit health and make sure that your credit score is healthy since this can be a huge factor that affects your ability to get loans. Luckily, you can monitor our credit on the Vital Card App. This lets you stay up-to-date on the real-time changes to your credit.

For more financial insights, check out our blog.


Types of Retirement Plans | DOL

401(k) and Profit Sharing Plan Contribution Limits | IRS

Individual Retirement Arrangements | IRS

Employer Sponsored Plans | Investor

Considering a loan from your 401(k) plan? | Internal Revenue Service

How Much Should I Contribute to 401(k)? | Experian

Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.