What is a 401(k) plan?
Many employers sponsor a retirement savings plan for their employees. Under these plans, also commonly known as defined contribution plans, you can save money toward your retirement on a tax-deferred basis – that is, you don’t pay federal or state income taxes on your savings or their investment earnings until you withdraw the money at retirement.
Most people’s taxable income – and therefore, their tax rate – is lower at retirement than during employment, so they end up paying considerably less in taxes on their savings.
The most common types of employer-sponsored retirement savings plans are called 401(k), 403(b) or 457 plans – so named for the Internal Revenue Service tax codes that govern them – and Thrift Savings Plans. Each has a different target audience:
- 401(k) plans are offered to employees of public or private for-profit companies.
- 403(b) plans are offered to employees of tax-exempt or non-profit organizations, such as public schools, colleges, hospitals, libraries, philanthropic organizations and churches.
- 457 plans are offered to employees of state and local municipal governments (and some local school and state university systems).
- Thrift Savings Plans are offered to federal civilian and uniformed services employees.
These plans have many features in common, although contribution limits, vesting schedules for employer-matching contributions, investment options and other details may differ, so be sure to read the plan documents for your particular plan carefully.
How do 401(k) Plans Work?
With a regular 401(k) plan, money is deducted from your paycheck before taxes are withdrawn, which lowers your taxable income and therefore, lowers your taxes.
Some plans allow you to contribute money on an after-tax basis as well. Check with your financial advisor for cases when this might be advantageous in your situation.
In addition, many employers have begun offering Roth 401(k) plans, which combine the features of a regular 401(k) with those of a Roth IRA. With a Roth 401(k) you contribute after-tax dollars. Although you don’t get an upfront tax break, your account grows tax-free and withdrawals aren’t later taxed, provided you’ve had the account at least five years and are age 59 ½ or older – or have become disabled or die.
Eligibility For Participation
Some employers apply a waiting period before you can begin participating in their 401(k) – anywhere from one month to one year – while others allow employees to begin making contributions immediately. Also, it’s not unusual for an employer to wait until you pass a similar waiting period before it will begin making matching contributions to your account. Check your benefits enrollment materials to see what, if any, waiting periods must be met.
The IRS sets a maximum amount you can contribute to a 401(k) plan in any given year and it is usually adjusted upward to account for inflation. For 2014, this limit is $17,500. In addition, employees over age 50 can also make “catch-up contributions” of up to $5,500 above and beyond the maximum amount.