Offered by employers, a 401(k) savings plan allows individuals to contribute part of their wages to a tax-deferred investment and savings plan. The amount that is contributed is not taxed until it is distributed or withdrawn from the plan.
The name was derived from Section 401(k) of the IRS tax code, and this savings plan has grown to become one of the most substantial ways that individuals can plan for their retirement.
Some plans allow an employee to make their 401(k) contributions without having taxes deferred. This type of plan is known as a Roth 401(k). When an individual retires with this type of plan, they will not pay any taxes when funds are withdrawn.
401(k) plans are governed by regulations that are stipulated in the tax code as well as the Employee Retirement Income Security Act of 1974.
Qualified Plans And Contribution Limits
A qualified plan can be either a defined benefit plan or a defined contribution plan. In the case of a 401(k) plan, it is a defined contribution plan since the balance of an employee’s fund is determined by the performance of the investment in the plan and by the contributions that have been made.
In some cases, an employer will contribute to the plan as well. This may be a dollar for dollar match or less, and it is based on a small percentage of the contributions made by an employee. However, employers are not required to make any contributions at all. Typically, this is the case with a pension plan.
In 2017, the contribution limits for an employee were set at a maximum of $18,000. However, if an employee turned 50 before the end of the year or was older than 50, they could also make a catch-up contribution that had a maximum cap of $6000.
In that same year, the maximum employee/employer joint contribution level was set at $54,000, up from the $53,000 level that was established in 2016.
Investments In A 401(k)
Typically, mutual funds are used in a 401(k) plan as an investment vehicle. However, in some cases, a plan can also include bonds or stocks. Index fund options are the most common as they offer a diversified mix of assets. This allows an employee to choose from conservative or higher risk investment vehicles.