A 401(k) is a defined contribution retirement plan that allows employees to have part of their pre-tax pay deducted from their paycheck and put into an interest-bearing account that will be held tax-free until such time as the money is actually used (generally at retirement). In some cases, the employer agrees to match each dollar that the employee contributes to the 401(k) plan with a contribution to the account. While some large employers match employee contributions dollar for dollar, most match at the rate of 50 cents on the dollar. There are two basic types of 401(k) plans, a bonus or profit-sharing plan, and a thrift plan.
Bonus plans. Under a bonus plan, contributions are generally not made until the end of the year when a traditional bonus is declared for all employees. Each employee may then elect to receive the bonus or the declared profit-sharing distribution in cash or have the amount contributed to the plan. The plan may allow an employee to take the entire bonus or distribution amount as either a cash bonus or as a plan contribution. Alternately, the plan may allow the employees to take part of the distribution in cash and part as a plan contribution.
Thrift plan. A thrift plan gives an employee the option of receiving a reduced salary (or foregoing a salary increase) and having the difference contributed to the plan. A fixed percentage of the employee's salary is then deducted from each paycheck and contributed to the plan on the employee's behalf. Generally, employees are given the additional option of changing their contribution levels once or twice a year. Many thrift plans provide for additional (matching) employer contributions.
Tax advantages. Participation in a 401(k) plan has several tax advantages. First, the employer is generally permitted to take a tax deduction for its contributions to the plan when the contributions are made. In addition, the employee pays taxes only for employer contributions, or portions of contributions, when he or she receives them in cash after retirement or separation from employment.
401(k) plans are the most popular retirement plans offered by small employers, at least judging from government survey statistics — according to the Bureau of Labor Statistics, 20 percent of employees in small business participated in a 401(k) plan when it was offered.
If a 401(k) plan sounds like something you're interested in, before you contact your business and financial advisors, check out our more detailed discussions of some related issues: