A Basic Guide to 401(k) Plans
401(k) plans are retirement plans that are designed to encourage long-term retirement savings by employees. The benefits are defined by the contribution levels written into the plan and are thus controllable. 401(k) plans need to meet a variety of rules contained in Section 401(k) of the Internal Revenue Code, but these plans are very popular among companies and employees.
Here are the key features of such plans:
- Employer contributions. The employer can contribute to the plan (subject to certain limits) for the employee's benefit, and the employee doesn't have to pay immediate income tax on that contribution.
- Employee contributions. The employee can elect to contribute a portion of his or her salary to the plan, and then the employee doesn't have to pay immediate income tax on that contributed salary.
- Investment of contributions. The employee can choose how to invest contributed money (in stocks, bonds, and other qualifying investments, for example).
- Tax deferral. The taxes on the contributions and the plan's investment earnings are deferred until the employee withdraws them (generally at retirement).
- Loan. In some instances, a participant may be able to take a loan against the 401(k) account, and as long as the employee repays the loan before taking a distribution from the plan, the funds remain tax deferred.
- Withdrawals. Unless the employee is age 59½ or anther exception applies (such as total disability), withdrawals by an employee may be subject to both a 10 percent penalty and regular income tax.
- Rollovers. Penalties and taxes generally do not apply if the employee changes jobs and "rolls over" his or her sums in the plan to the new employer's qualified plan that accepts rollovers. Penalties and taxes can also be avoided in certain circumstances for rollovers into an IRA.
The nature of a 401(k) plan can be drafted to accommodate certain employer needs, subject to qualifying with the appropriate tax rules.
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