What is a 401(k) Plan?

A 401(k) plan is a type of qualified retirement plan. It is typically sponsored by a company, although there are various other entities such as schools and non-profit organizations that offer 401(k) plans to employees.

A primary distinction of a 401(k) plan is that it offers to employees what is referred to as a salary deferral arrangement. A salary deferral is an amount of an employee’s salary that is deferred — that is to say tax deferred — until the employee withdraws the money from the plan.

The benefit to the employee is that salary deferrals are contributed pretax. This not only lowers the employee’s taxable income, it potentially saves money for retirement tax-free during the working years when a person is generally in a higher tax bracket than that of the retirement years.

In addition to the salary deferral feature, many 401(k) plans provide a matching contribution on part or all of an employee’s salary deferrals. There are various formulas that an employer may use for the matching contribution. It could be a percentage of the deferral, such as 50% of the first 5% of salary deferred. It could also be a dollar for dollar contribution. No matter the formula, over time the matching contributions can grow into large balances and be a significant benefit to participants in the 401(k) plan.

Another important aspect of 401(k) plans is that by law they have to be non-discriminatory in design. Aside from excluding union or non-resident aliens, a company generally cannot set up a 401(k) plan so that it is only available to a certain group, such as owners, or to specific employees. However, there are rules that allow for the 401(k) plan to require employees to work a certain number of hours in a year. Since the hours requirement cannot be greater than 1000 per year, many part-time employees would still be eligible to participate.

Like any retirement plan, the principal idea of 401(k) plans is that they provide long-term investment earnings potential that enables participants to save assets for retirement. Compounding the savings potential is the inaccessibility of the money once a participant has contributed to the 401(k) plan. The assets are not easily withdrawn. The participant must have an allowable reason according to the rules of the employer’s 401(k) plan. The most common allowable reason, which perfectly illustrates the difficulties of withdrawing the balance, is termination of employment.

To alleviate the hesitation many participants would feel about putting their hard earned money into a largely untouchable account, many 401(k) plans include a loan feature. A 401(k) loan allows participants to take money out of their 401(k) account. Typically, the loan can be taken for any reason. There are restrictions on the amount of the loan, and the loan has to be set up so that the participant repays the loan regularly. The benefit to the loan is that the interest rate will always be fair, and the repayments — including interest — goes back into the participant’s account.

Most industry professionals agree that withdrawing one’s money from a 401(k) plan should only be done as a last resort. The tax ramifications are heavy, and the damage to the earnings potential by reducing one’s account balance is substantial. A 401(k) plan account should be treated as exactly what it is — a long-term retirement savings solution.