401(k) Plan

What Is a 401(k) Plan?

A 401(k) plan is a type of defined contribution plan offered by many private employers in the United States. It takes its name from a subsection of the Internal Revenue Code that allows employees to save for retirement by directing part of their pay into an investment account. The plan is set up and run by the employer, often with the help of a plan provider, and the assets are held for the benefit of the participating employees.

How It Works

Employees choose a percentage of each paycheck to contribute, and that amount is deducted automatically before it reaches their bank account. The contributions are invested in a menu of options selected by the plan, which commonly includes mutual funds and target-date funds. The account value depends on how those investments perform, so it can rise or fall over time.

Traditional 401(k) contributions are made before income tax is applied, which lowers taxable income for the year they are made. Investment gains generally are not taxed until money is withdrawn. Many plans also offer a Roth option, where contributions are made after tax and qualified withdrawals in retirement are generally tax-free.

Many employers add an employer match or another contribution, which is a major reason these plans are so widely used. Employer contributions may be subject to a vesting schedule, meaning the employee must work for a set period before owning the full amount.

Withdrawals and Job Changes

Withdrawals taken before about age 59½ are generally subject to income tax plus an additional early withdrawal penalty, although exceptions exist. Once account holders reach the age set by federal rules, traditional accounts are subject to required minimum distributions. When a worker changes jobs, the balance can often be left in the old plan, moved to the new employer's plan, or rolled over into an individual retirement account (IRA).

Advantages and Disadvantages

The main advantages are the tax treatment, automatic saving through payroll deduction, and the possibility of employer contributions. The main disadvantages include a limited set of investment choices, fees that vary from plan to plan, and restrictions on accessing the money before retirement. Plan documents and fee disclosures describe the available investments and their costs.