What is a 401(k) retirement plan?

A 401(k) is a retirement savings plan that allows an employee to save money for retirement and invest it in a variety of investment tools, while deferring income taxes on the saved money and the earnings until the money is withdrawn.

• 401(k) plans are typically sponsored and designed by a corporation.
• A main benefit of the 401(k) plan is in that the employee does not incur taxes on the contributions to the plan.

How does a 401(k) plan work?

As an employee, you decide to have a percentage of your pay allocated or ‘deferred’, into your employer’s 401(k) account.
In participant-directed plans, which are the most common type of 401K plan, you as an employee can select from a number of investment options:

• Mutual funds, stocks
• Bonds
• Money market investments
• Or a blend of options to suit your retirement planning strategy.

You can generally re-allocate money among these investment choices at any time.
In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan´s assets will be invested.

Many companies’ 401(k) plans offer specific benefits.

• The option to purchase the company´s stock.
• Company matching funds, with which the company will match an employee’s contributions to the savings plan up to a certain threshold.

For example, a company may offer to match up to 5% of its employees’ contributions.  If you make $50,000 a year as an employee and you elect to make a contribution of 5% of your salary to your 401(k), you will be investing $2,500 (5% x $50,000) each year and your company will contribute an additional $2,500 (their 5% match) each year. The matching funds are essentially “free money”, in the sense that your employer is adding money to your retirement fund at no cost to you.    

The Tax Benefits

Most 401(k) contributions are on a pre-tax basis or tax deferred, which means that when you direct money to a 401(k) plan, you can delay paying taxes on the funds until  some future period.

• By deferring taxes on your 401(k) to a later period, you are able to invest more money now toward your retirement, and are also able to have a higher return on the amount of money that you deferred when the 401K is cashed out.

Technically, all 401(k) contributions are on a pre-tax basis (i.e., no income tax is withheld on the income in the year it is contributed), and the contributions and growth on them are not taxed until the money is withdrawn.

What happens to your 401(k) plan if your employment changes?

If you retire or leave your job you have the option to cash-out or roll-over your 401(k):

• The 401(k) account generally stays active for the rest of your life, though the accounts usually must begin to be withdrawn beginning April 1st of the calendar year in which you reach age 70½ or in which you retire.
• The account can be “rolled over” into an IRA at an independent financial institution.
• If you take a new job at a company that also has a 401(k) or other eligible retirement plan, you can "roll over" the account into a new 401(k) account hosted by the new employer.

Roth 401K

In a Roth 401(k) qualified distributions are tax free, but income tax is paid or withheld on the contributions to the account. The Roth 401(k) may be appealing to you instead of a traditional 401(k) if you are willing to give up the tax break now in return for getting the tax break at retirement.

• Most participants in 401(k) plans can allocate some or all of their contributions to a separate designated Roth account, which has similar tax effects of a Roth IRA.