More Americans are saving for retirement than ever before. Research from Gusto Insights found that if you work for a small business, there's a good chance your employer is now part of that story. The share of small businesses offering active retirement plans has risen nearly 60% since 2019, bringing 5.6 million more workers into plans their employers actually use. Workers are also involved: more than half of small business employees with access to a plan now participate, including strong gains among hourly workers and lower-income earners.
A 401(k) is one of the most valuable savings tools available to you. Whether your employer offers a match or not, participating can be a savvy financial decision — and getting started is more straightforward than most people expect.
What is a 401(k)?
A 401(k) is a retirement plan that many employers offer to help their employees save for retirement. The primary advantage of contributing to your 401(k) plan (instead of a normal investment account) is that the contributions (non-Roth) you make are tax deferred.¹ That means the money is taken directly from your paycheck before any income taxes are taken out of it, and it grows tax-free in your 401(k) plan.
If you withdraw funds from your 401(k) before you reach age 50 ½ you'll be forced to pay stiff penalties — or interest if you want to borrow against the value of your account. You will be subject to income taxes when you decide to withdraw non-Roth funds from your 401(k). The tax benefit for some people comes because they may be taxed at a lower rate during retirement than they were when they made the 401(k) deferrals from their paychecks. If everything else is equal, due to the tax savings, that means your nest egg might grow a bit bigger if you build it by investing in your 401(k) plan instead of a normal investment account.1
What is the difference between a traditional and Roth 401(k) account?
What’s the difference between a traditional 401(k) versus a Roth 401(k)?
Traditional 401(k) retirement accounts allow individuals to set aside a share of their paycheck on a pre-tax basis. This means that the IRS taxes these funds when the individual receives a distribution from the plan.
On the other hand, Roth 401(k) accounts allow employees to contribute on an after-tax basis. While that means you won't be taxed on qualified withdrawals in the future2, it also means your contributions may take a bigger bite out of your paycheck today.
Does your company match your 401(k) plan contributions?
Some employers choose to match a portion of the funds their employees contribute to their 401(k) plans. If your employer matches your contributions, it means they're essentially giving you free money when you contribute to your 401(k) plan.
The good news: matching is more common than you might think, especially at small businesses. According to Gusto payroll data, about 70% of small businesses with an active retirement plan contribute to their employees' accounts — and among those that do, the typical match is around 3% of gross pay. That means if you earn $60,000 a year and your employer matches 3%, you could be leaving $1,800 on the table every year by not deferring up to your employer match. Employer matches are good for you because it means you'll be adding more money to the compound returns machine.
What are compound returns?
In the simplest terms, compound returns — the "returns on your returns" that your investments earn. For example, if you invest $100 and earn 10% annually, you would earn $10 in the first year. In Year 2, you also earn interest on the interest from Year 1, which means you'll earn $11. And in Year 3, you'll earn 10% on $121 (i.e., $12.10) and so on. Your $100 investment would double in around seven years if you were lucky enough to earn 10% annually.3
Should I pay off existing debt first?
This is probably one of the most crucial factors in your decision to sock money into a 401(k) plan. If you have a lot of household debt, like student debt, then it's likely that it's accruing interest. If that debt is for your house, student loans, or your car, then the interest rate is probably pretty low — 5% or lower. However, if you have credit card debt or personal loans, the rates can be well above 15%.
Doing the math, taking advantage of an employer match can mean an instant return on your 401(k) investment. If your employer matches 50% of your contributions, that means an instant return of 50%. But people who carry high-interest debt often prefer to pay off their debt before they save, even when their company offers a match. Historically, a typical S&P 500 Index Fund has returned about 7% annually4, so if the interest on your debt is higher than 7%, you could wind up paying more in interest than you'll earn on your investments.
However you look at it, it's probably a good idea to have a foreseeable path to paying off that high-interest debt before you commit too much to your 401(k) plan. If you can defer some of your salary into a 401(k), get matching funds, and still whittle away at the debt, it's probably worth it. Again, the ability to save and pay off debt depends a great deal on the amount of debt you have, and your ability to live within your means.
Will you need liquidity in the near term? If you need your salary for household expenses or are saving to buy a car, a house or another big-ticket item in the next year to 18 months, you should perhaps weigh the decision to contribute to your 401(k) plan very carefully.
Money you put into your 401(k) plan is often left alone until you're ready to retire. Yes, some plans allow you to borrow money from your account or take distributions early, but you will be subject to fees, penalties, taxes, and you'll miss out on the compounding effects that time will have on your retirement balance.1
It's important to think about your retirement on a short-term and long-term basis. Be careful of being so eager to save in the short-term that you wind up putting yourself in a bind. Similarly, it can be prudent to have an emergency fund with enough cash to cover expenses for a few months. It's a good idea to make sure you have what you need to weather any short-term financial storms.
How to prioritize your 401(k) contributions
There are so many factors in personal finance that it's hard to know where to start the decision-making process. We all have basic costs of living like rent or mortgage payments, bills, and transportation costs. And some of us have things like childcare expenses and medical bills.
But once all those basics are settled, where should saving money via a 401(k) be on your list of priorities? Keeping in mind the caveat that everyone's personal finance situation is different, here's a rough list to think about:
Pay off high-interest debt: Nothing hangs financial dread over you like credit card balances and other high-interest debt. Consider getting those balances paid off pronto, or, at the very least, think about consolidating credit debt to lower your rates so you're confident you can pay down these debts before they balloon.
Build up an emergency fund: The AARP Public Policy Institute survey found that 53% of American households do not have an emergency savings account. Startlingly, half of people over 50 do not have one, potentially putting them at risk for tapping into their retirement savings prematurely when an unexpected bill hits.
Grab that employer match in your 401(k) plan: If your employer matches your contributions, consider taking advantage of it as soon as you can. It's not uncommon for some companies to match as much as 6% of your income, so the benefits of taking full advantage of matching can be huge.
Save for major purchases: If you're saving for a down payment, a wedding, or some other major purchase, it often makes sense to prioritize it just below paying off high interest loans and taking advantage of the free money in your employer match.
Contribute to a Roth plan: If you've maxed out your employer match, but still want tax-advantaged savings, consider a Roth 401(k) plan or IRA. Roth options can be beneficial because you pay most income taxes up front, but then its earnings are generally tax-free2. If you wind up being in a higher tax bracket than you are now when you retire (which could be the case if you're just starting your career), then a Roth can be more beneficial. If you think it's more likely that you'll be in a lower tax bracket when you take the distributions, however, a Roth may not be as advantageous.
Non-matched 401(k) or IRA contributions: If you've exhausted the previous steps, the next thing to consider is a Traditional 401(k) plan (sans match) or IRA. Even if your employer's 401(k) plan doesn't offer a match, you can still get a great tax benefit by deferring part of your pre-tax pay into investments that will grow over time. Never underestimate the power of compound returns!3 Likewise, getting some money into a Traditional IRA may allow you to take a deduction on your tax return.1 The deadline for IRA contributions to qualify for a tax deduction on your return is typically April 15 of the following year.
529 plans: If you have kids and want to save for their education, a 529 plan is a great way to accomplish that. Many states offer a deduction for contributions to a 529 plan, and the earnings and distributions are usually tax-free if they are used for qualified education expenses for your child. And just like saving for a 401(k), compound returns benefit you in a 529 plan.3
Other investments: If you've tapped out all the above, any extra funds can be stored in other investments like real estate, stocks, bonds, trusts, or other assets.4
Lower interest loans: Finally, you can start chipping away at the principal on your low-interest loans. This borrowing is usually for automobiles, homes, or other long-lived assets.
Pro tip: Make sure you understand the fees associated with your 401(k) plan. On their own, 401(k) plans have some great tax advantages, but many plans charge employees fees of over 1% per year, which can have a huge impact over time.
Happy saving!
The fact that you're thinking seriously about this stuff probably means you're on a better path than most Americans. So should you participate in your employer's 401(k) plan? If they offer to matching contributions, then it's an especially good opportunity to save. Just be sure you take into consideration your whole personal financial situation before you commit money to your 401(k). Consider any high-interest debt that might be a burden, and as well as think about your short-term financial needs so that any surprises won't undermine your long-term goals.
FAQs
Should I participate in my employer's 401(k) plan?
In most cases, yes — especially if your employer offers a match if you are financially able. A 401(k) match is essentially free money added to your retirement savings, making it one of the highest-return financial moves available. Even without a match, the tax-deferred growth of a 401(k) makes it a powerful long-term savings tool. The main exceptions: if you're carrying high-interest debt (above ~7%) or have no emergency fund, addressing those first may make more sense. Take into consideration your entire personal financial situation before deciding.
What is the difference between a traditional and Roth 401(k)?
With a traditional 401(k), contributions come out of your paycheck pre-tax, lowering your taxable income today, but you will likely pay income taxes when you withdraw funds in retirement. With a Roth 401(k), contributions are made after-tax, meaning your paycheck takes a bigger hit now, but qualified withdrawals in retirement are typically completely tax-free.² If you expect to be in a higher tax bracket in retirement, Roth tends to be more advantageous; if you expect a lower bracket, traditional may be better.
Should I pay off debt before contributing to my 401(k)?
It often depends on the interest rate. For high-interest debt (credit cards, personal loans above ~7–15%), paying it down first often makes more financial sense than investing, since the interest you're paying may outpace your investment returns. For lower-interest debt (mortgages, student loans, car loans), it might make sense to contribute to your 401(k), especially enough to capture any employer match — while also paying down the debt.
What are compound returns and why do they matter for retirement?
Compound returns means you earn returns not just on your original investment, but also on the interest and gains you've already accumulated. For example, $100 earning 10% annually becomes $110 after year one, $121 after year two, and roughly $200 after seven years — without adding a single dollar.3 In a 401(k), this compounding happens tax-advantaged, making time in the market one of the most valuable factors in building retirement wealth. Starting early, even with small contributions, can have an outsized long-term impact.
