401(k) Basics: How It Works and 2026 Limits

What a 401(k) is

A 401(k) is a retirement savings plan sponsored by an employer. You choose a percentage of your pay to contribute, and the money is taken from each paycheck and invested in options your plan offers, such as funds. Because contributions come out automatically, saving happens without you having to remember to do it.

The IRS describes these contributions as elective deferrals. They are salary reductions, generally set as a percentage of your pay, although some plans allow a fixed dollar amount per pay period.

Pre-tax versus Roth

Traditional, or pre-tax, 401(k) contributions reduce your taxable income now, and you generally pay income tax when you withdraw the money in retirement. Roth contributions work the other way. According to the IRS, designated Roth contributions are included in your income when you make them but are tax-free when distributed, if the rules are met.

If a plan offers a Roth option, it must also offer pre-tax deferrals. Which one is better depends on your situation, including whether you expect to be in a higher or lower tax bracket in retirement. Some people split their contributions between the two. A tax professional can help you decide.

Employer contributions

Many employers add money to your account. The IRS explains that employer contributions can be matching contributions, which depend on how much you defer, or nonelective contributions, which are made for all eligible participants whether or not they contribute.

A match can be discretionary or mandatory. As an example, the IRS describes a safe harbor plan where the employer matches 50 cents for each dollar you defer. Matching formulas differ widely, so read your plan's summary. If you are not contributing enough to receive the full match, you may be leaving part of your pay package unclaimed.

The 2026 limits

The IRS sets limits on how much you can contribute each year. For 2026, the 401(k) elective deferral limit is $24,500, up from $23,500 in 2025 according to the IRS. The limit is the lesser of that dollar amount or 100% of your compensation. If your deferrals exceed the limit, the excess is included in your gross income.

People age 50 or older at the end of the calendar year may make catch-up contributions above the basic limit if their plan allows. Reported figures for 2026 put the standard catch-up at $8,000, for a total of $32,500, and a higher catch-up of $11,250 for ages 60 to 63. The IRA limit for 2026 is $7,500, with a $1,100 catch-up for people 50 and over.

401(k) versus IRA

An individual retirement account, or IRA, is something you open yourself rather than through an employer. IRAs have a lower annual limit than a 401(k) and their own tax rules, including income limits for some benefits. Many people use both: a 401(k) to capture an employer match and a larger savings total, and an IRA for extra savings or more investment choices.

Because the IRA rules around tax deductions and Roth eligibility depend on your income and whether you have a workplace plan, check the current IRS rules or ask a tax professional before choosing between them.

Common mistakes

A few habits cost people money over time.

• Not contributing enough to get the full employer match.
• Forgetting to raise your contribution when your pay goes up.
• Cashing out when changing jobs. Rolling the balance into your new plan or an IRA keeps it invested; taking the cash can trigger taxes and penalties.
• Putting all your money in one investment instead of spreading it across funds.
• Draining retirement savings for emergencies. A separate emergency fund protects your retirement account from being raided.

Choosing how much to contribute

There is no single right rate, but a few anchors help. First, contribute at least enough to receive your full employer match. Second, if you can, work toward saving a meaningful share of your pay over time rather than a fixed dollar amount, so your savings grow as your income does. Third, check whether your plan offers automatic escalation, which raises your rate by a set amount each year.

The annual limit is a ceiling, not a target. Most people will not reach $24,500 in a year, and that is fine. What matters most is starting early and staying consistent, because time in the market lets your contributions and any earnings compound. If your budget is tight, even a small percentage is better than none, and you can raise it with each pay rise.

Remember that contributions come out of your paycheck before you see them, so your take-home pay falls by less than the amount you contribute when you choose pre-tax. Use your pay stub to check the effect after you change your rate.

Getting started

Ask your employer's benefits team for the plan summary, the match formula and the investment options. Then pick a contribution rate you can sustain, and increase it a little each year. Even small increases add up over a long career.

If you are carrying high-interest debt, you may want to balance paying it down against getting your match. A nonprofit credit counselor can help you build a plan. Keep in mind that this guide is general information, not personal financial advice, and the limits above are for 2026 and will change in later years.