Definition
401(k) Plan: A retirement savings and investment plan offered by employers that allows employees to contribute a portion of their wages to individual accounts before taxes are deducted.
Meaning
By contributing to a 401(k) plan, employees reduce their taxable income, potentially realizing tax savings in the year of contribution. The funds in a 401(k) grow tax-deferred, meaning they are not subject to taxes until they are withdrawn, typically during retirement.
Etymology
Named after the section of the Internal Revenue Code—section 401(k)—that established this type of retirement saving plan in the United States in 1978.
Background
Initiated as part of the Revenue Act of 1978, the 401(k) plan was designed to supplement pensions and provide employees with more control over their retirement savings. It has become one of the most popular methods for retirement savings in the U.S.
Key Takeaways
- Pre-tax Contributions: Employees contribute pre-tax dollars, thereby reducing taxable income.
- Employer Matching: Many employers match a portion of the employee’s contribution, offering free retirement funds.
- Tax Deferral: Funds grow tax-free until withdrawal, usually taxed at potentially lower rates during retirement.
- Contribution Limits: Annual contribution limits are set by the IRS.
- Roth Option: Some 401(k) plans offer a Roth option that uses after-tax dollars but allows for tax-free growth and withdrawals.
Differences and Similarities
Differences:
- Traditional vs. Roth 401(k): Traditional uses pre-tax contributions, while Roth uses post-tax contributions with tax-free growth.
- 401(k) vs. Pension: 401(k) plans are defined contribution plans primarily funded by employees. Pensions are defined benefit plans funded by employers guaranteeing a specific retirement benefit.
Similarities:
- Both aim to provide financial security during retirement.
- Both offer tax advantages to encourage savings.
Synonyms
- Deferred Compensation Plan
- Employer-sponsored Retirement Plan
Antonyms
- Unfunded Plan
- Non-qualified Plan
Related Terms with Definitions
- IRA (Individual Retirement Account): A retirement account individuals can contribute to independently of their employer.
- Defined Benefit Plan: A traditional pension plan where the employer provides a specified payout in retirement.
Frequently Asked Questions
What is the maximum contribution limit for a 401(k)?
For 2023, the IRS has set the contribution limit at $22,500 for under 50, and an additional $7,500 in catch-up contributions for those 50 and older.
Can I access funds in my 401(k) before retirement?
You can, but early withdrawals are typically subject to penalties and taxes, except under certain hardship conditions or loan provisions specified by the plan.
What happens to my 401(k) if I change employers?
You can roll over your 401(k) into another retirement account, such as an IRA or your new employer’s 401(k) plan, to maintain the tax-deferred status.
Quotations from Notable Writers
“What you do today can improve all your tomorrows.” – Ralph Marston
Related Government Regulations
- Employee Retirement Income Security Act (ERISA): Sets minimum standards for most voluntarily established retirement and health plans.
- Internal Revenue Code, Section 401(k): Governs the establishment and operation of 401(k) plans.
Literature and Further Reading
- “The Index Card: Why Personal Finance Doesn’t Have to Be Complicated” by Helaine Olen and Harold Pollack.
- “Smart Portfolios: A Practical Guide to Building and Maintaining Intelligent Investment Portfolios” by Robert Carver.
- IRS Publication 590: Individual Retirement Arrangements (IRAs) for detailed regulations on retirement plans.
In the words of Benjamin Franklin, “An investment in knowledge pays the best interest.” Make your 401(k) decisions wisely to ensure a golden future. Happy planning!
James S. Robinson, Your Friendly Pension Guide
