What Is 401(k) Plan?


Quick Answer

A 401(k) is an employer-sponsored retirement plan. Employees voluntarily defer part of their current income by a designated amount that may be matched by their employer in order to receive tax-deferred earnings.

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What Is 401(k) Plan?
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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 The employee does not pay taxes on the 401(k) account's earned interest until the money is withdrawn.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.

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