What is a 401k Plan?

Michael Teague  |

A 401k is a Qualified Retirement Plan, meaning simply that it meets the stipulations of the Internal Revenue Code, and is thus eligible for tax benefits. 401k plans are intended solely for employees of a given business or company and their beneficiaries. Someone who is retired typically has three different sources of income: Social Security, their savings account, and their retirement plan, which may be sponsored by their employer (in other words a Qualified Plan) or through an Individual Retirement Account.

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There are several varieties of Qualified Plans, and the 401k is categorized as a defined-contribution plan, which means that retirement benefits are dependent upon how much an employee decides to contribute to it (through payroll deductions), as well as how much of these contributions an employer decides must or decides to match. It is important to note that contributions to defined plans are invested ostensibly on behalf of the employee, and employers are not mandated to make up for any losses incurred from the investment decisions they have made with that money. Other examples of defined-contribution plans include Profit-Sharing plans, Money-Purchase pension plans, and employee stock ownership plans.

A 401k plan hinges on what is called a CODA, a cash or deferred arrangement, meaning that the employee is permitted to defer a certain percentage of their salary or wages toward the plan, which is typically done prior to tax deductions. The contribution made by an employee is itself known as an elective-deferral contribution for the reason that a given employee voluntarily decides how much money to set aside, and waits to receive it until it is distributed to them.

An employee has the option to access the money in their 401k prior to their retirement, but may be taxed up to 10 percent as a result. There are exceptions to this, however, for instance when an employee becomes disabled, or after he or she separates from the company.

Certain 401k plans allow employees to have a hand in what investments are made with their contributions by offering a choice of investment products from which to choose. In other cases, the employer hires a professional to oversee and make decisions about how the money is invested.

There is a sub-category of 401k known as the SBO-401k, which is intended for small-business owners who employ themselves and their spouses. No other employees of the business can be eligible, but such a plan does give small business owners the possibility of having their own retirement savings plan.

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