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401(k) Participation
Contributions are generally not subject to federal income taxes until they are distributed.
Any investment gains and earnings also enjoy tax deferral until distribution.
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There are two standard groupings of employer-sponsored retirement plans: defined benefit (DB) and defined
contribution (DC). In a DB plan, the employer promises to pay a defined amount to retirees who meet certain
eligibility criteria. These plans define the benefit to be received. Benefits are usually linked to the
amount of service and based on final average salary, and are traditionally paid out over an employees
lifetime. The plan sponsor may provide an alternative lump-sum 'cash-out' of the benefit entitlement.
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In DC plans, the plan defines the contributions that an employer can make, not the benefit that will be
received at retirement. The terminating employee receives the proceeds in a current or deferred lump sum
or annuity. Since the benefit is not defined, the retirement outcomes are not known in advance.
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In 1978, section 401k of the Internal Revenue Code authorized the use of a new type of defined contribution
plan that allows for the employee to make pre-tax contributions to the plan.
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How It Works
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Employee contributions are automatically taken from paychecks on a pre-tax basis. The contributions are
invested at the employees direction into one or more funds provided in the plan. Employers sometimes 'match'
employee contributions, but are not required to do so. While the investments grow in the employees 401k
account, employees do not pay any taxes on it.
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401k plans offer many benefits to employees, including:
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Contributions to plan can come from voluntary employee salary reduction or from employer, or both.
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Each individual employee can defer in 2004 up to $13,000 or 100% of compensation, whichever is less. This will increase $1,000 each year till $15,000 in 2006.
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Participants age 50 and over can make additional 'catch-up' contributions of $3,000 in 2004 which will increase each year by $1,000 until $5,000 in 2006.
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Employers are not required nor obligated to make any contribution to the 401k, although employer may have some obligation to contribute if plan is deemed top heavy.
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401k plans may permit 'self-directed investment accounts' and company stock purchase within the plan.
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Employee contributions to the plan are not subject to federal income taxes until a distribution from the plan is made. Any investment gains and earnings also enjoy tax deferral until distribution.
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Loans and hardship withdrawals are generally permitted.
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Participants can start, stop contribution during course of year, as determined by the company.
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401k plans have some restrictions for employees, including:
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Employee withdrawals before age 59 1/2 may be subject to 10% penalty.
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Employees who retire any time during the calendar year in which they turn 55, or later, are not subject to the 10% penalty.
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Typically the amount the owners and highly compensated individuals can contribute to a 401k is a function of the contributions of the other employers.
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