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401(k)

A 401(k) plan is a type of qualified defined contibution retirement plan established by employers for the benefit of employees.

Contents

Expanded Definition

The 401(k) retirement plan gets its name from the Internal Revenue Code section and paragraph that delineates the protocols within which it operates -- Section 401, paragraph (k). The law that created this section of code went into effect on January 1, 1980.

Employers adopted it fairly quickly as a means of reducing the burden and responsibility of funding employee retirements. By the same token, it also gave employees more power and flexibility over their retirement.

Here's how it works: A separate account for each employee is established within the 401(k) plan. If part of an employee's pay is contributed to the retirement plan, the contribution can be made with either pre-tax dollars or after-tax dollars at the employee's option. Within the plan current taxes are deferred until the money is withdrawn at some later date, usually at retirement. Additionally, all the earnings on those contributions are deferred until the money is withdrawn from the plan, as well. That tax deferral adds an enormous kicker to the compounding effect of those deposits during the employee's career.

Most employers who have such plans offer an inducement to encourage employees to participate through a matching contribution on some part of the employee's deposit. A typical matching arrangement would be an employer deposit of 50 cents on the dollar up to 6 percent of the employee's pay. On that match, if the employee contributed 6 percent of pay, the employer would match it through a 3 percent contribution. In effect, the employee gets an immediate return of 50 percent on the first six percent of pay contributed.

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