The 401(k) plan is a type of defined contribution pension plan available in the United States. Named after a section of the 1978 Internal Revenue Code, it is a device to provide tax advantages on money set aside for retirement. Other types of defined contribution plans include 403(b) plans covering workers in non-profit entities and the 457 plan that covers employees of state and local governments.
401(k) plans must be sponsored by an employer, typically a corporation. The employer acts as a plan fiduciary and is responsible for creating and designing the plan as well as selecting and monitoring plan investments.
The employee asks to have part of his salary paid directly, or deferred, into the 401(k) fund. In participant-directed plans the employee can then select from a number of investment options. In trustee-directed 401(k) plans the employer appoints trustees who decide how the plan's assets will be invested.
Taxes on contributions to 401(k) plans and the earnings on those contributions are deferred until the money is withdrawn from the plan. At the time money is withdrawn from the plan it is taxed as regular income. Withdrawals are typically made at or after retirement. In most cases in which employees take money taken from accounts prior to retirement they must pay a 10 percent penalty to the IRS.
Theodore Benna, a consultant working for The Johnson Companies, created the first 401(k) plan in 1980. During the decade of the 1990s the plan proved popular with workers because it has more flexibility than Individual Retirement Accounts, known as IRAs. 401(k) plans have higher yearly contribution limits than IRAs. Also, 401(k) plans are tax-qualified plans covered by the Employee Retirement Income Security Act of 1974 (ERISA) which means that assets held by the plans are protected from creditors. That protection does not apply to IRA accounts in some states.
Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at a low, pre-defined interest rates. The interest proceeds then become part of the 401(k) balance.
401(k) plans also proved popular with employers looking for ways to reduce their pension costs. In most cases, defined contribution plans are less expensive than defined benefit plans for employers. 401(k) plans also create a predictable cost for employers while the cost of defined benefit plans can vary unpredictably from year to year.
At present, there are a number of financial-advice sites on the Internet that describe these plans in their free-content sections.