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A 401(k) plan allows a working person in the US to defer income taxes in order to save for retirement. It is very similar to an IRA except for the fact that is administered by the employer. A person can choose to 'contribute' a certain amount of his pre-tax salary in the 401k, which is often matched by his/her employer, and reduces his immediate tax liability. All contributions and gains on the account are tax-deferred until the money is withdrawn from the 401k -- this is different from the Roth 401(k), which allows the account holder to deposit after-tax income, and withdraw it tax-free. A person is allowed to have both a 401(k) and an IRA.

Most 401ks are participant-directed, which means that the employee can select from a number of investment options, such as mutual funds, bonds, and money market investments. The employee usually has the option to change allocation between these asset classes. In trustee-directed 401(k) plans, the employer appoints trustees who make investment decisions on behalf of all employees.

The employee cannot withdraw from the 401k until he/she reaches the age of 59½, except under special circumstances. Withdrawals before that age are typically subject to 10% penalty (as well as income taxes). Starting at the age of 70½, employees must take minimum distributions, i.e. they are required to withdraw, from the 401k account. This applies to both regular 401(k) and Roth 401(k) accounts. This is mandatory, unless the account holder continues to work for the employer who sponsored the plan at the age of 70½. For a Roth 401(k) account, mandatory required minimum distributions do not apply if the assets are rolled over to a personal Roth IRA. after separation of service.

Benefits of a 401(k) plan

• Money contributed into these plans are "pre-tax dollars," which means, taxes are not paid on these deposits until the money is withdrawn from the retirement plan.

• For income below $200,000, individuals can defer up to $15,500 for the year 2008 and $16,500 for 2009. Individuals above 50 can contribute an additional $5,000 in 2008 and $5,500 in 2009. Total contribution, i.e. contribution by employee plus employer contribution, cannot exceed the lesser of $46,000 or the employee's annual salary in 2008.

• Employees are immediately 100% vested with their own tax deferred contributions, and if they leave their employer, they can roll their account into an individual personal IRA, or to a new company's 401K.

• Some plans offer "matching" contributions from their employer, i.e. the employer will contribute an amount proportional to the individuals own contribution. For example a 5% match means that the employer will match contributions up to 5% of the employees annual salary. In other words, if someone earns $50,000, and contributes $4000 to his/her 401(k), the employer will contribute a maximum of $2500 (5% of salary). In some cases, the match is not dollar-for-dollar and employers may only match 50%, or 25% of the employee's own contribution. Many would argue that the company match is the greatest advantage of a 401K as the immediate 'return' generated by the matching donations allows for faster acquisition of capital.

• Some 401k's allow investment changes about once a quarter, others may allow more frequent changes.

• Some plans offer direct loans, hardship loans and disability loan provisions against the 401(k).

• Deferring taxes allows a person who is will be in a lower tax bracket during retirement, than while he is saving up for retirement, to benefit from a lower tax rate.

Disadvantages of a 401(k) plan

• Investment choices in 401k's may offer a limited number of investment choices to choose from.

• Withdrawals from any retirement plan: 401k, 403b, 457 plan or IRA 's are income taxable when the money is withdrawn. If the person is below the age of fifty nine and a half years (except hardship cases and other special situations) there is an "IRS Early withdrawal 10% penalty" in addition to deferred taxes.
  • Exceptions include: the death of the employee, total and permanent disability, separation from service in or after the year the employee reached age 55, a qualified domestic relations order, and deductible medical expenses, exceeding the 7.5% floor.

• Employers have the option to restrict individuals with less than 1 year of service, union members, non US citizens, part-time workers etc., from being eligible for the plan.

401(k) vs. IRA

• The maximum limit for 401(k) plans are substantially higher than the limit for IRA. In 2008, individuals under 50 were allowed to contribute $15,500 to 401(k) plans, whereas they could only contribute $5,000 to an IRA.

• Employers make matching contributions to 401(k), however there is no such provision for the IRA.

• An individual can borrow money from the 401(k) without paying a penalty, but not from an IRA. The borrowed money from a 401(k) is not treated as an income but has to be paid back with interest.

• Some mutual funds forego load fee for 401(k) accounts.

• IRAs offer lot more flexibility in terms of investments. Not only does an investor have more options through an IRA, he can also change his investments positions much more easily (and frequently) in an IRA account than in a 401(k).

• There is no hassle of rolling over an IRA plan from one employer to the next.

How to start a 401(k) plan

401(k) plans are offered through an employer. By participating in this plan, an employee authorizes the employer to retain part of their salary for these plans. Most human resources departments will have details on starting such an account with the employer.

When leaving an employer, a employee can choose to leave the 401(k) with his old employer -- in many cases, employers will charge a fee for managing 401(k) plans of ex-employees. An individual can also cash out his 401(k), but this would result in a penalty of 10%. The best option is to rollover a 401(k) from one employer to the next.