A 401(k) plan is a defined contribution plan that is a cash or deferred arrangement. Employees can elect to defer receiving a portion of their salary, which is instead contributed on their behalf, before taxes, to the 401(k) plan.
Sometimes the employer may match employee contributions. There are special rules governing the operation of a 401(k) plan. For example, there is a dollar limit on the amount employees may elect to defer each year. The dollar limit is currently $10,500. The amount may be adjusted annually by the US Treasury Department to reflect changes in the cost of living. Other limits may apply to the amount that may be contributed. For example, if highly compensated employees may be limited depending on the extent to which rank and file employees participate in the plan. Employers must advise of any limits that may apply to its employees.
Although a 401(k) plan is a retirement plan, access to funds may be permitted before retirement. For example, active employees may be allowed to borrow from the plan. Also, a plan may permit withdrawals on account of hardship, generally from funds contributed by the employee. The sponsor may want to encourage participation in the plan, but it cannot make elective deferrals a condition for the receipt of other benefits, except for matching contributions.
The adoption of 401(k) plans by a state or local government or a tax-exempt organization is limited by law.
401(k) Tax Advantage for Employees
One advantage of a 401(k) plan is that employee contributions can be made on a pretax basis. As such, the employee's taxable income is reduced by the amount contributed.
For example, an employee making $25,000 a year who contributes 5 percent ($1,250) to a 401(k) plan reduces the amount on which income taxes are levied to $23,750.
Taxes are deferred, however, not eliminated: when the employee begins withdrawing funds from the plan, taxes must be paid on the pretax contributions, any employer-matching contributions and any earnings on these contributions.
Introduction to 401(k) Plans
Employer-sponsored pre-tax saving plans, often called 401(k) plans, differ from traditional employer-sponsored retirement plans in that eligible employees are permitted to make pre-tax contributions to the plan. Most employers match the contributions (typically with a match rate of 50 percent up to six percent of compensation). With the matching provision, a higher contribution limit, and no adjusted gross income phase-out of deductibility, 401(k) plans have a greater potential for pre-tax saving than do Individual Retirement Accounts.
The term 401(k) refers to the section of the Internal Revenue Code that allows employees to choose to have a portion of their compensation (otherwise payable in cash) invested in a qualified defined contribution plan on a tax-deferred basis.
Employers may find 401(k) plans a cost-effective way to offer pension benefits to workers with different preferences. The employer need only make a contribution (if they match) for workers who have already made a contribution.
Because the saving is tax-favored, the Internal Revenue Service imposes contribution limits, and restricts participant access to the funds. The plan must pass certain nondiscrimination tests to remain tax-qualified.