A 401(k) plan is a retirement account to which employees designate a portion of their pre-tax income through payroll deductions. The employee decides how the funds are invested from among low or high risk options. Typically, account owners wait until retirement age to withdraw the funds.
One of the main advantages of a 401(k) plan is that the contributions and investment gains are not taxed until the account owner withdraws funds from the account. Additionally, many employers match a portion of the employee's contribution. Although there is a yearly contribution limit to a 401(k) plan, once an employee is 50 years or older, he can add additional catch-up contributions. When an employee gets a job with a different employer, he can usually either leave the 401(k) account active with the former employer or roll the funds over tax-free into the new employer's 401(k) plan.
According to IRS rules, if a 401(k) plan owner withdraws money before reaching the age of 59 1/2, he must pay regular income tax and a 10 percent penalty tax on the distribution. Exceptions to the penalty include distributions made due to the complete disability of the owner, medical expenses totaling more than 10 percent of the plan holder's adjusted gross income, a military reservist being called to active duty for 180 days or more and the arrangement of substantially equal periodic payments. A plan owner must initiate required minimum distributions upon reaching the age of 70 1/2.