DEFINITION of '401(k) Plan'
A 401(k) plan is a qualified employer-established plan to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Employers offering a 401(k) plan may make matching or non-elective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings in a 401(k) plan accrue on a tax-deferred basis.
BREAKING DOWN '401(k) Plan'Caps placed by the plan and/or Internal Revenue Service (IRS) regulations usually limit the percentage of salary deferral contributions. There are also restrictions on how and when employees can withdraw these assets, and penalties may apply if the amount is withdrawn while an employee is under the retirement age as defined by the plan. Plans that allow participants to direct their own investments provide a core group of investment products from which participants may choose. Otherwise, professionals hired by the employer direct and manage the employees' investments.
The 401(k) plan was enacted into law in 1978 and is named after the subsection of the Internal Revenue Code that established it. As of the end of 2015, 401(k) plans accounted for roughly $4.7 trillion of the $24 trillion in total retirement plan assets in the United States. Total 401(k) plan balances have increased by more than 100% from 2008 to 2015.
Popularity of 401(k) Plans
Participation in 401(k) plans continues to grow. More than 50 million workers are active participants in their employers' 401(k) plans, with over half a million different company plans in place. Once criticized for their high fees and limited options, 401(k) plan reform has made several changes benefiting employees.
The average plan offers nearly two dozen different investment options, while fund expenses and management fees have continued to drop. Additional features such as automatic enrollment, increased fee visibility, more low-cost index fund options and catch-up contributions for near-retirees have been added to many plans. Additionally, contribution limits are indexed to inflation, allowing participants to make larger contributions to plans over time.
Traditional and Roth 401(k) Plans
One of the greatest advantages of the 401(k) plan is the tax-advantaged nature of contributions and earnings. The traditional 401(k) plan allows employees to make pre-tax contributions to the plan, but it taxes withdrawals from the account. Established in 2006, the Roth 401(k) offers participants another tax-advantaged option; contributions are made with after-tax dollars, but withdrawals are fully tax-free so long as certain conditions are met. The Roth 401(k) option is available in more than 50% of company 401(k) plans.