What is 401(k) ?

The 401(k) is a kind of retirement plan named after a section of the Internal Revenue Code of the United States. The plan involves deduction of a certain amount of cash, decided by the employee, from the employees’ salary before taxes are determined. This amount is then invested in the 401(k) plan.

The 401(k) plan is a type of profit sharing plan and differs from a conventional pension plan as contributions are voluntary. One of the advantages of this scheme is that the employee gets to decide how the money is invested.

Besides, the gains made due to investments under the 401(k) plan are not taxable. The maximum amount that can be put into the plan is determined each by the IRS (Internal Revenue Service).

In 1978, Congress amended the Internal Revenue code to add section 401(k). Under the 401(k) system, the employer becomes the fiduciary, who is in charge of designing and implementing the system and for selecting and overseeing the investments made. However, in a majority of cases, the employers outsource this to other external entities such as banks, mutual fund, etc.

As per law, the money needs to be kept in the 401(k) system or in any similar retirement plan until the employee reaches the age of 59.5. The employee also has the option of withdrawing the amount prior to attaining this age. However, the amount withdrawn will be taxable at relatively high rates. The rate of taxation of these is around 10 percent of the amount. However, the taxation is exempted if the withdrawal is due to a pre-defined hardship that the employee faces such as the purchase of primary residence, medical expenses which are not taken care of by insurance, etc., funeral expenses of a spouse etc. The employers may forbid one or more of the predefined hardship definitions Employees, generally, prefer to withdraw the amount if necessary if they find themselves in a lower tax bracket.

In addition, there are provisions that enable the employee to draw loans on the 401(k) account at predefined rates. Besides, the fact that the 401(k) is protected under the Employee Retirement Income Security Act (ERISA) means that they are protected against bankruptcy unlike ordinary pension plans. The employer does not have access to your 401(k) account for any purposes related to business. It is held in a separate account.

When an individual resigns from his job, the account will still be active for the rest of his life. However, on attaining the age of 70.5 the account must start to be withdrawn.

Experts, however, remind that investing in the retirement plan that your company provides is only a part of a solid retirement plan. They recommend that you maintain other savings apart from the retirement plan offered by your company.