A 401(k) is a retirement plan offered by a business organization that allows employees to begin saving pretax income. Contributions are made from the employees’ salary and often matched by employers.
A 401(k) plan (commonly referred to as a defined contribution plan) takes its name from subsection 401(k) of the Internal Revenue Code. This retirement plan permits employees to set aside a portion of their pretax income. Depending on what the plan allows, employees can also contribute to the 401(k) on a post-tax basis. Regardless, earnings from investments within the 401(k) account are tax-deferred. Employers offering a 401(k) plan may make equivalent contributions to the plan on behalf of eligible employees. A major benefit of a 401(k) is the consequential compounding interest with postponed taxation. For pre-tax contributions, the employee does not pay federal income tax on the sum of income that he/she defers to a 401(k) account. The employee eventually pays taxes on the money as he/she extracts the funds, customarily during retirement. The IRS and in some cases the plan itself often place caps limiting the percentage of salary deferral contributions that can be placed in the 401(k) account. Restrictions have also been placed on the availability of assets after being placed in a 401(k) account to the participating employee. If an employee chooses to withdraw from the 401(k) plan while under the retirement age as defined by the plan, penalties may occur. Some plans provide a core group of investment products from which participants can choose. Otherwise, the employer hires professionals to direct and manage the employee’s investments.