401(k) basics: don’t leave free money behind

What a 401(k) actually is

A 401(k) is a retirement savings account offered through your employer. You contribute a percentage of each paycheck — before or after taxes, depending on the type — and that money gets invested in funds you choose from a menu your employer provides. It grows tax-advantaged until you retire.

The name comes from a section of the tax code, which tells you everything you need to know about how Washington works and nothing about how useful the account actually is. The useful parts: the tax advantages and — for most workers — the employer match.

The employer match: an instant return

Many employers match a portion of your contributions. A common structure is something like: the employer matches 50% of your contributions up to 6% of your salary. That means if you earn $60,000 and contribute 6% ($3,600/year), your employer adds another $1,800 — for free.

That's a 50% instant return on $3,600 before the market does anything at all. No investment in the world reliably delivers that. Not contributing enough to capture the full match is, in plain terms, turning down part of your compensation. Check your plan documents or ask HR what your specific match formula is — and contribute at least enough to get every dollar of it.

Pre-tax traditional vs. Roth 401(k)

Most employers now offer two flavors: the traditional 401(k) and the Roth 401(k). The difference is when you pay taxes.

With a traditional 401(k), contributions come out of your paycheck before income taxes. That lowers your taxable income today, which means a smaller tax bill this year. But you'll owe ordinary income tax when you withdraw the money in retirement.

With a Roth 401(k), you contribute after-tax dollars — no tax break now. But the money grows tax-free, and qualified withdrawals in retirement are completely tax-free. If you think your tax rate will be higher in retirement than it is now, Roth is usually the smarter choice.

Vesting: the fine print on free money

Employer match contributions often come with a vesting schedule — meaning you don't fully own that money until you've worked there for a certain number of years. If you leave before you're fully vested, you forfeit some or all of the match.

Common vesting schedules include cliff vesting (you own 0% until year three, then 100% all at once) and graded vesting (you earn ownership in percentages over four to six years). Before you job-hop, check where you stand on the vesting schedule — leaving six months early can cost you thousands.

The right order of operations

When you have limited money to allocate across retirement vehicles, order matters. Here's the sequence most financial educators recommend:

• Contribute enough to your 401(k) to capture the full employer match — this is the highest-return move available to most workers
• If you're eligible, max out a Roth IRA next — it gives you more investment options and more flexibility than a 401(k)
• Come back and contribute more to your 401(k) up to the annual limit if you have money left over
• After that, taxable brokerage accounts or HSA (if you have a high-deductible health plan) are good next steps

The reason to detour to a Roth IRA between steps one and two is flexibility. Roth IRA contributions (not earnings) can be withdrawn anytime without penalty, and you have access to a broader fund menu than most 401(k) plans offer.

Raise your contribution 1% per year

Most people set their 401(k) contribution percentage once — during onboarding — and never change it. That's a mistake. The most painless way to build retirement wealth is to increase your contribution by one percentage point every year, ideally timed with a raise.

If you get a 3% raise and simultaneously bump your 401(k) from 6% to 7%, your take-home pay still goes up — just not by the full raise amount. You barely feel the contribution increase because it's absorbed by the raise. Over a decade of 1% annual bumps, you go from contributing 6% to contributing 16%, which can translate into dramatically more retirement wealth.

Common 401(k) mistakes to avoid

• Not contributing enough to get the full employer match — this is leaving compensation on the table
• Cashing out a 401(k) when you change jobs — this triggers income taxes plus a 10% early withdrawal penalty before retirement age
• Leaving your money in the default investment option without reviewing whether it matches your timeline
• Forgetting about old 401(k) accounts from previous employers — consider rolling them into your current plan or an IRA
• Waiting until you 'can afford it' — even 3% today is better than 10% starting in five years

A 401(k) is not complicated once you understand the mechanics. Contribute enough to get the match, choose a diversified fund (a target-date fund that matches your expected retirement year is a solid default), increase contributions annually, and don't touch the money until retirement. That's most of what you need to do.