What Is a 401(k) Plan?


Quick Answer

A 401k plan allows employees to contribute portions of their wages to their respective individual accounts for the purpose of retirement planning. Employees work with their employers to invest in several types of 401k plans.

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Full Answer

An employee's 401(k) contributions are deducted from his pay automatically and require very little effort on the part of the employee. The deductions are made either before or after taxes, and employers often match the employee's contributions. The employee does not pay taxes on the 401(k) account's earned interest until the money is withdrawn. Ideally the employee is in a lower tax bracket during his retirement, and the funds are taxed at a lower rate. The 401(k) account has the added benefit of reducing the employee's taxable income when funds are deducted pre-tax. This reduces the account holders current tax debt as well.

An employee may be able to withdraw funds from his 401(k) in case of hardship or to purchase a home. Depending on the employer's plan, workers may withdraw up to 50 percent of their account balances. This loan must be paid back with interest. When an employee leaves an employer, he is able either to maintain his 401(k) or transfer the funds to a new retirement account.

Aside from traditional 401k plans, another type includes SIMPLE plans. These provide small businesses the opportunity to assist their employees in retirement planning by relieving them of the non-discrimination tests subject to traditional plans. There are also other employer requirements, dependent upon the rules of each plan, such as matching contributions. Additionally, employees are able to gain tax deferral on their contributions, until distributions of funds begin.

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