A 401k plan allows a worker to save for retirement and have the savings invested while deferring current income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wages paid directly, or "deferred," into his or her 401(k) account (i.e., is a pension). This deferment is also known as a "contribution".
401(k) plans are mainly employer sponsored plans; the employer can, as a benefit to the employee, optionally choose to "match" part or all of the employee's contribution by depositing additional amounts in the employee's 401(k) account or simply offer a profit sharing contribution to the plan.
In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many compnay 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time at his/her discretion.
Most 401(k) contributions are on a pre-tax basis. Starting in the 2006 tax year, employees can either contribute on a pre-tax basis or opt to utilize the Roth 401(k) provisions to contribute on an after tax basis and have similar tax effects of a Roth IRA. However, in order to do so, the plan sponsor must amend the plan to make those options available. With either pre-tax or after tax contributions, earnings from investments in a 401(k) account (in the form of interest, dividends, or capital gains) are not taxable events. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over long periods of time.
For pre-tax contributions, the employee does not pay federal income tax on the amount of current income that he or she defers to a 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year's tax return. Currently this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket and there were no other adjustments (e.g. deductions). The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement.
For after tax contributions to a designated Roth account (Roth 401(k)), qualified distributions can be made tax free. To qualify, distributions must be made more than 5 years after the first designated Roth contributions and not before the year in which the account owner turns age 59 and a half, unless an exception applies as detailed in IRS code section 72(t). In the case of designated Roth contributions, the contributions being made on an after tax basis means that the taxable income in the year of contribution is not decreased as it is with pre-tax contributions. Roth contributions are irrevocable and cannot be converted to pre-tax contributions at a later date.
Withdrawal of funds
Virtually all employers impose severe restrictions on withdrawals while a person remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before the age of 59½ is subject to an excise tax equal to ten percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year). This penalty is on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee's total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor).
Required minimum distributions
An account owner must begin taking distributions from their accounts by April 1 of the calendar year after turning age 70½ or April 1 of the calendar year after retiring, whichever is later. The amount of distributions is based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. Required minimum distributions apply to both pre-tax and after-tax Roth contributions. Only a Roth IRA is not subject to minimum distribution rules.
There is a maximum limit on the total yearly employee pre-tax salary deferral. The limit, known as the "401(k) limit" is $15,500 for the year 2008 and $16,500 for 2009 and 2010. For future years, the limit may be indexed for inflation, increasing in increments of $500. Employees who are 50 years old or over at any time during the year are now allowed additional pre-tax "catch up" contributions of up to $5,000 for 2008 and $5,500 for 2009. The limit for future "catch up" contributions may also be adjusted for inflation in increments of $500. In eligible plans, employees can elect to have their contribution allocated as either a pre-tax contribution or as an after tax Roth 401(k) contribution, or a combination of the two. The total of all 401(k) contributions must not exceed the maximum contribution amount.
If the employee contributes more than the maximum pre-tax limit to 401(k) accounts in a given year, the excess must be withdrawn by April 15 of the following year.
Plans which are set up under section 401(k) can also have employer contributions that (when added to the employee contributions) cannot exceed other regulatory limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, which is the lesser of 100% of the employee's compensation or $44,000 for 2006, $45,000 for 2007, $46,000 for 2008, and $49,000 for 2009. Employer matching contributions can be made on behalf of designated Roth contributions, but the employer match must be made on a pre-tax basis.
Governmental employers in the US (that is, federal, state, county, and city governments) are currently barred from offering 401(k) plans unless they were established before May 1986. Governmental organizations instead can set up a section 457(g).