How does a 401(k) work?

You do not move money into a 401(k). You instruct your employer to pay you less and send the difference to the plan. That distinction matters: the money is never in your possession, which is why traditional contributions reduce your taxable income automatically without you claiming anything on your return.

Defer 10% of a $70,000 salary and $7,000 goes to the plan. If it is a traditional deferral, you are taxed as though you earned $63,000. The plan buys the funds you selected, and from then on nothing inside the account is taxed year to year. Dividends, interest and gains all compound untouched.

The bill arrives at withdrawal, when everything you take out is taxed as ordinary income.

Most plans now offer both. A traditional deferral gives you the deduction today and taxes the withdrawal. A Roth deferral gives you no deduction today and makes qualified withdrawals tax free.

The rough rule: choose Roth if you expect your tax rate in retirement to match or exceed today's, which often favors people early in their careers. Choose traditional if you are at a peak earning point and expect to retire into a lower bracket. Splitting between the two hedges the fact that nobody knows future tax rates.

One detail people miss: even if you choose Roth deferrals, the employer match typically goes into the traditional side, so most Roth 401(k) savers end up with both anyway.

A match is your employer contributing alongside you. A common shape is 100% of the first 3% of pay you contribute plus 50% of the next 2%, giving 4% of pay if you contribute 5%.

Contributing less than the match threshold leaves money behind that has no equivalent anywhere else in investing. This is why the standard first step is to contribute at least enough to capture all of it.

Vesting is the catch. Your own contributions are always fully yours. Employer contributions may require you to stay a set period before they become yours: cliff vesting hands you the whole amount at once after, say, three years, while graded vesting releases it in slices. Leaving before you vest forfeits the unvested part.

Unlike an IRA, a 401(k) offers only the menu your plan provides, typically ten to thirty funds plus a set of target-date funds. You cannot buy individual stocks in most plans.

Because the menu is fixed, the one variable genuinely in your control is cost. Expense ratios inside plans range from about 0.03% to well over 1%, and over decades that gap compounds into a serious sum. Comparing the expense ratios on your plan menu is a ten-minute task with an outsized payoff.

The balance is yours regardless. Four options:

Leave it. Usually allowed above a minimum balance. Simple, but easy to forget, and you keep whatever fees that plan charges.

Roll it to your new employer's plan. Keeps everything in one place.

Roll it to an IRA. Opens up the whole investment universe instead of a fixed menu, and usually cuts costs. Note that a large pre-tax IRA balance complicates a future backdoor Roth.

Cash it out. The expensive one. Income tax plus a 10% penalty under 59 and a half, and the compounding is gone for good.

Contributing below the match. The single most costly and most common one.

Leaving the default. Auto-enrollment often starts at 3%, a number chosen to be painless, not sufficient.

Losing track of old plans. Several small accounts across former employers, each with its own fees and none reviewed, is a common and avoidable drag.

2026 deferral and catch-up limits are from IRS Notice 2025-67. Plan mechanics, vesting and rollover rules are covered by the US Department of Labor. Walnut is informational and is not an investment adviser. This guide is educational and not personalized tax or investment advice; anything with a tax consequence is worth confirming with a tax professional.