Employees of private companies can choose this retirement plan to contribute a part of their pre-tax salary to enjoy the benefits as a retiree. The contributions made are then reinvested in the money markets in stocks, bonds or securities. An employee is thus able to set aside a certain percentage of his income into a tax-deferred investment account selected by the employer. Salary reduction plan is another term for it.

401(K) retirement plan comes in two categories, defined benefit and defined contribution. A defined benefit plan is one in which the employer commits to payment of a predetermined amount to retirees who fulfill the eligibility criteria. In a defined contribution plan, the contributions to be made by the employer are defined but not the benefit to the employee at the time of retirement.

As 401(K) is an employer-sponsored plan, the employer is in the role of a fiduciary for the plan. His responsibilities include creation and design of the plan, in addition to choosing and regulating all investments under the plan. Almost all employers prefer to outsource this entire process to financial service companies like banks, mutual funds and insurance companies.

The employee chooses to get a part of his salary directly channelised into the 401k account. Sometimes companies add to the contributions by putting additional money into the employee’s 401k account to give the employee and incentive to increase savings for retirement. When an employee changes jobs, his 401k account can usually be valid for a lifetime.

Tax benefits

Federal income taxes don’t have to be paid by the employee on the amount of current income deferred to a 401k account. All investment earnings in a 401k account are only taxed when withdrawn. The compound interest that results minus taxation makes a major benefit of the 401k plans in the years to come.

Often employees can also avail loans from their 401k accounts, which have to be repaid with after-tax funds at pre-defined interest rates. Then the interest proceeds are added to the 401k balances. The loan is not considered taxable income nor does the 10% penalty apply, provided repayment is done before departing from service or as soon as separation occurs.