What it is Why we like it Who is eligible What it isn't Contributions Loans Distributions and withdrawals Changing jobs What It Is A 401(k) plan is a tax-deferred investment and savings plan that acts as a personal pension fund for employees. It allows employees of corporations and private companies to save and invest for their own retirement. In a 401(k) plan, you authorize pre-tax payroll deductions to be invested in mutual funds or other investment options offered by your company's plan. Both the contributions and the investment earnings can grow tax-deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income. 401(k)s were established by the federal government in 1981 to encourage workers to establish retirement savings plans. The name refers to the relevant section in the Internal Revenue Code. Why We Like It Tax-Deferred Contributions and Earnings Your contributions are taken pre-tax, reducing your taxable salary, and both the contributions and earnings can grow tax-deferred until they are withdrawn. Tax-deferred contributions and earnings make up the best one-two punch in investing. Compare the Results Choice and Portability You choose whether or not you want to participate in a company's 401(k) plan and how much you want to set aside. Under ERISA regulations, the plan must offer a number of different investment options, which means you get to select your investments based on your own time horizon, risk aversion, and financial risk tolerance. 401(k) plans are also portable. When you change jobs, you don't have to leave your 401(k) behind. You can roll over your account into another employer's 401(k) plan or into an IRA. Built-In Dollar Cost Averaging Because participant contributions are typically a percentage of an employee's salary, which is more-or-less the same every pay period, you invest the same amount every pay period. This is what's termed Dollar-Cost Averaging, a much-touted tenet of successful investing. To use the dollar-cost averaging strategy, you put the same amount of money into an investment at regular intervals, such as every month. Since, over the long term, the stock market has consistently risen, you are likely to end up buying more shares when prices are low and fewer shares when prices are high. And, you don't have to track the market and time your purchases (that is, buy low and sell high). The Company Match Provision Employer contributions, which are optional, typically come in the form of what's called a "company match." These can range from 25% to 100% of your contribution to the plan, up to a certain limit. Most employers (over 80%) offer some type of this company match--both as an incentive for employees to join the plan and as part of the overall benefits package. Many consider these employer contributions the real attraction of the 401(k) account. In a plan where your employer is matching your contribution at 50 cents on the dollar, you've made an instantaneous 50% return. Who Is Eligible? Depending on your company's 401(k) rules, you may be able to contribute to a 401(k) in any year you earn a salary and are a regular employee. The administrative costs involved in setting up and maintaining a 401(k) plan generally makes it attractive only to companies with more than 25 employees. What It Isn't A 401(k) is different from a company pension plan in a few ways: Benefit. With a 401(k) plan, benefits depend on individual contribution levels and portfolio performance. A pension plan has predetermined benefits based on final salary, years of service, and a fixed percentage rate. Transferability. You can roll a 401(k) account into another 401(k) plan or an IRA, but when you leave a company, your pension generally stays there. Investment Allocation Decisions. Each participant in a 401(k) makes decisions for his or her own portfolio. A plan administrator makes decisions for the future "pensioners." Funding. The employees, along with (most) employers, fund the 401(k) plan while company pensions are funded by employers only. See SEP-IRA, SARSEP-IRA, SIMPLE-IRA, and Keogh, to learn how other tax-deferred retirement plans offered by businesses differ from the 401(k). To see which retirement plan is right for your business,click here. Contributions Contributions to a 401(k) can come from both employees (often called participants) and employers. Participant contributions are called salary reduction contributions, because they are pre-tax deductions taken from each paycheck, which reduces your taxable salary. Some plans do allow after-tax contributions, which are taken from your net pay. The contribution is taken after-tax and is non-deductible, but the earnings grow tax-deferred until retirement, when they are taxed like ordinary income. Each year, the Internal Revenue Service sets a maximum contribution limit for 401(k) accounts. For the 1999 tax year, the employee contribution limit is $10,000. Employer contributions, which are optional, typically come in the form of what is called a "company match". These can range from 25% to 100% of your contribution to the plan, up to a certain limit. Most employers (over 80%) offer some type of this company match both as an incentive for employees to join the plan and as part of the overall benefits package. Many consider these employer contributions the real attraction of the 401(k) account. In a plan where your employer is matching your contribution at 50 cents on the dollar, you've made an instantaneous 50% return. While the participant owns participant contributions (and their related investment earnings), employer contributions accrue to the participant over a period of time, typically between 3-7 years, called a vesting period. Over time, employer contributions are added to the participant contributions to become what's called the vested balance, which is owned by the employee. Loans Many plans allow loans to be taken from your 401(k) account. Once you reach a minimum vested balance (determined by the plan), you may be eligible to take a loan from your 401(k) account. Repayment takes place through automatic payroll deduction. In addition to repayment of loan principal, you also repay a fixed rate of interest to your account. In essence, you are borrowing from and repaying yourself. Taking a loan from your 401(k) account can have significant consequences for the growth of the account. You lose out on the earnings growth that would have occurred if the loan amount were still in the plan. Additionally, unlike some loans, the interest payments on 401(k) loans are not tax deductible. Because these plans are meant for retirement savings, there are usually restrictions, including those on loan frequency and loan amount. Check with your plan sponsor for more details. Distributions and Withdrawals Withdrawals from 401(k) plans are often referred to as distributions. Assets in your 401(k) account can be withdrawn without penalty after age 59?, and you must begin to withdraw money from your account no later than April 1 of the year following the year in which you turn age 70?. Distributions must be taken annually. Distributions taken after age 59? are subject to the following tax treatment: For pre-tax contributions: Both the contributions and the investment earnings are treated as income. For after-tax contributions: The contributions are treated as a nontaxable return of capital, but all investment earnings are treated as income. An excise tax may apply if distributions from all of your qualified retirement plans--401(k)s, 403(b)s, IRAs, tax-deferred annuities, etc.--are greater than $160,000 in a single calendar year. The 15% tax is only applied to amounts over $160,000. Lump-sum distributions from qualified plans may be subject to the excise tax for amounts greater than $800,000. Note: This excise tax has been suspended until January 1, 2000, at which time it will be reinstated. 401(k) plans do not actively promote the ability to withdraw money from your 401(k) account before age 59?. In fact, some plans require you to take a loan from the plan before you can take a withdrawal. Most plans do, however, offer the ability to withdraw from your 401(k), which, under IRS regulations, must be for an "immediate and heavy financial need." These so-called "hardship withdrawals" are allowed for the following reasons: Unreimbursed medical expense for yourself or a dependent Purchase of primary residence College tuition for yourself or a dependent To prevent eviction or foreclosure If you take a hardship withdrawal, the plan sponsor will set aside 20% as a prepayment of your federal taxes. An additional 10% premature withdrawal penalty may apply. There are some exceptions to the 10% premature withdrawal penalty, including: Disability (as defined by the IRS) A separation of service (after age 55 and prior to age 59?) If your withdrawal is distributed in the form of "substantially equal payments" made at least annually over your life expectancy or the joint life expectancy of you and your designated beneficiary Payments for certain unreimbursed medical expenses under the Internal Revenue Code Distributions to alternate payees required through Qualified Domestic Relations Orders (as might be issued in divorce proceedings) If you are considering taking a withdrawal, check with your plan sponsor or the IRS for more details. Changing Jobs When you change jobs, you have a number of options regarding your 401(k) account: Roll it over into another qualified retirement plan, like a 401(k) plan or an IRA. You don't have to leave your 401(k) behind. You can roll over your account directly into another qualified retirement plan, such as your new employer's 401(k) plan or an IRA, called a Rollover (or Conduit) IRA. By doing so, you avoid any penalty or withholding tax. To ensure a direct rollover, be sure that your former 401(k) plan's trustee makes the check directly payable to your IRA's custodian or to your new 401(k) plan's trustee. Take a lump sum distribution (full or partial). If you decide to take a distribution before age 59 1/2, the financial costs can be steep. In addition to a 10% premature withdrawal penalty, your plan sponsor is required to set aside 20% for federal withholding tax on the amount you don't rollover directly. This is only an estimate of the tax you'll owe on the withdrawal--the actual amount will be determined when you file your taxes. Leave it where it is. If the vested balance in the account is over $3,500, most plans will let you leave it in the plan until age 70? or retirement, whichever is later. The tax information provided is for informational purposes only and is not intended, and should not be construed, as tax advice or a recommendation. Intuit does not provide legal, tax, or investment advice and you should consult with a professional tax advisor about your individual circumstances.