Overview: 401(k) plans (named after subsection 401(k) of the Internal Revenue Code) are defined contribution retirement plans in which employees elect to defer a portion of their salary, on a pre-tax basis, to a retirement savings account. Although not required, many employers make matching contributions to their employees' 401(k) plans.
Pre-tax contributions can be made up to an annual limit. Additionally, many plans provide for additional catch-up contributions for employees over age 50. Both the annual limit and the catch-up contributions may be adjusted for inflation. Employees do not pay federal income taxes on the amounts contributed to a 401(k) plan. Instead, taxes are paid when the employee withdraws money from the account (generally during retirement), at which time it is taxed as ordinary income.
Money must generally be kept in the 401(k) (or another tax deferred plan) until an individual reaches age 59 and one-half. Withdrawals made prior to age 59 and one-half usually incur a 10 percent excise tax in addition to ordinary income taxes. There are limited exceptions to the 10 percent excise tax, some of which include:
Trends: The increased focus on fees and fee disclosure requirements benefits both employers and employees. Employers can use this information to shop around for the best plan for their workforce, and employees have a better understanding of how much they are paying for their 401(k), which, in turn, allows them to be more educated consumers.
Author: Tracy Morley, SPHR, Legal Editor
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