What is a 401k retirement plan?

Section 401k plans are qualified retirement plans offered by companies in the private sector, which allow their employees to elect whether to receive their wages as cash, or put portions of them aside to invest in the retirement plan. The money deferred accumulates tax-free until retirement or upon the occurrence of a triggering event when are distributions are supposed to start.

Characteristics of a 401k Retirement Plan

401k is a so-called CODA (cash or deferred arrangement) plan in which employees have the freedom to choose between receiving their salaries cash, or deferring part of their wages and using them to fund their retirement plans. The deferred contributions are not taxed but they become taxable when distributions begin.

At each employer's discretion, 401k plans can be established that are funded by both the employee and the employer. Typically, employers offer a matching contribution of up to 50 percent the amount contributed by the employee as an incentive for the workers. However, employers reserve the right to take away their contributions from the 401k plan if the employee leaves the job at any point during the vesting period (usually five years).

The majority of 401k plans allow the participants to select what to invest the funds in. 401k plans provide a whole range of investment possibilities: bond funds, common stock, mutual funds, fixed-income funds, etc. It is common among a company's employees to invest part of their contributions in company stock. However, you should beware of investing too much into the company's stock as there is always the possibility that the company will declare bankruptcy, especially in the conditions of a recession.

There are limits as to what portion of their wages individuals can defer every year. The 401k elective deferral maximum contribution amounts increase almost every year with inflation. For the year 2009, employees under age 50 can contribute a maximum of $16,500, with the additional catch-up contribution for over-50s being $5,500. Thus, participants over 50 can contribute an aggregate maximum of $22,000 for the year 2009.

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