How Does a 401(k) Plan Work?

A 401(k) is a tax-deferred savings plan for employees. It is named after the section of the Internal Revenue Code that created it. Employers offer 401(k) plans to recruit, retain and reward workers. By sponsoring a 401(k), and perhaps contributing to it, companies can also help employees reach a secure retirement.

Contributions

A 401(k) is a defined-contribution plan that allows the employee and employer to choose their contribution amounts, within federal guidelines. You simply tell your employer how many pretax dollars you want deducted from you paycheck and contributed to your account, based on company and IRS rules. As of 2012, the IRS allows a maximum annual contribution of $17,000 by employees before they reach age 50, plus another $5,500 for plan participants 50 or older. The maximum annual employer contribution is $33,000. The overall limit is the lesser of $50,000 or 100 percent of your annual salary for an employee age 49 or younger and $55,000 for someone 50 and older.

Custodian

The Employment Retirement Income Security Act requires that 401(k) contributions be held in a custodial account. Such an account may be with an investment company, which invests the money in financial securities to meet defined investment objectives. The money must remain invested until you reach at least 59 1/2 year old to avoid an early withdrawal penalty. The investment company charges a fee for its services, typically a percentage of the managed assets.

Vesting

Your 401(k) contributions are yours regardless of your employment status with a company. However, the employer determines when you have a right to keep any employer-matching contributions if you leave your job. For example, the employer may require you to work for three years of full-time employment to be fully vested in the matching funds.

Changing Jobs

If you change jobs, you can keep your money in your former employer's plan, cash out your retirement savings, or roll your money into an IRA or your new employer's 401(k) plan. You must arrange a direct rollover, or the check you receive must be written to the new plan's administrator, to avoid paying taxes on your contributions and a 10 percent penalty. The check must also be received by the new plan within 60 days of the withdrawal from your old plan. Many employers allow you to leave your money in their 401(k) plan if you have not reached retirement age and your account balance is $5,000 or more.

Distributions

The IRS taxes your 401(k) distributions at your regular income tax rate when the funds are distributed in retirement. The IRS considers any disbursements before you reach age 59 1/2 an early withdrawal, for which you will pay a 10 percent penalty. This penalty also applies to withdrawals after age 70 1/2.