What is a 401(k) Plan

A 401(k) plan is a qualified employer-sponsored retirement plan that eligible employees may make salary-deferral contributions to 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.

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Introduction To The 401(K)

BREAKING DOWN 401(k) Plan

Caps placed by the plan and Internal Revenue Service 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 there is a withdrawal while an employee is under the plan's defined retirement age. Plans that allow participants to direct their own investments provide a core group of investment products participants may choose from. Otherwise, employers hire professionals to direct and manage the employees' investments.

The 401(k) plan became law in 1978 and is named after the subsection of the Internal Revenue Code that established it. As of Sept. 30, 2017, 401(k) plans accounted for roughly $5.3 trillion of the $27.2 trillion in total retirement-plan assets in the United States, according to the Investment Company Institute. Total 401(k) plan balances have increased by more than 100 percent from 2008 to 2017. 

Popularity of 401(k) Plans

Participation in 401(k) plans continues to grow. As of 2015, more than 50 million workers are active participants in their employers' 401(k) plans, and there are more than 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 that benefit 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 half of company 401(k) plans.