What are Corporate 401(k) Plans?

A 401(k) is a retirement plan that is sponsored by an employer and allows employees and employers to make pre-tax contributions for their retirement. 401(k) plans have become tremendously popular and plan providers have improved dramatically over the last few years and now offer many more services such as increased investment selection, reduced administrative costs and efficient administration.

401(k) Contributions and Withdrawals

A 401(k) participant can elect to defer up to 100% of their W-2 compensation up to a maximum of $16,500 in 2010. 401(k) participants that will become age 50 or older during the calendar year January 1 - December 31 and are making the maximum contribution are permitted to make an additional "catch-up" contribution. In 2010 the maximum annual catch-up contribution is $5,500. As a result, those age 50 or older can contribute $22,000. Employee contributions are 100% tax deductible and dividends and investment earnings grow tax-deferred until they are withdrawn.

In general, withdrawals from a 401(k) before age 59 ½ incur a 10% IRS penalty and are taxed as income. After age 59 ½ an employee can withdraw the money without penalty, but will pay income taxes. This is advantageous for many investors because they are able to make a contribution to their retirement plan and receive a tax deduction during their working years while in a higher tax bracket, get many years of growth in dividends and investment earnings without being taxed, and when retired and typically in a lower tax bracket, they withdraw the money as needed.

401(k) Loans

Some 401(k) plans have a loan provision which allows employees to take a loan. Tax free loans (up to 50% of the total 401(k) value with a $50,000 maximum) are permitted. Loans must be repaid according to the terms of the loan amortization schedule which is provided when a loan is initiated. Failure to repay the loan according to these terms may result in a loan default causing income taxes as well as IRS penalties.

Generally the total loan balance is due within a short time period (60 or 90 days) upon voluntary or involuntary termination of service with an employer. If the full remaining balance of the loan can't be repaid at that time, then the loan is considered defaulted which may cause taxes and IRS penalties.

401(k) Company Match Options

Employers are not required to make contributions on behalf of employees in a 401(k) plan. Although not required, many employers do make contributions called a "company match." A common employer match is a 1 for 2 match up to a maximum of 3%. For example, if an employee contributed 6% of their salary an employer would contribute 3% for the employee.

Frequently, there would be a vesting schedule on the company match. When there is a vesting schedule an employee would need to work for an employer for a specified time period or else they may receive none or only a fraction of the company match. Of course, employee contributions do not have a vesting schedule and are immediately 100% vested. A company match can reward loyal employees and frequently improves employee retention and helps to attract new employees. Learn more about how an employee benefits from a 401(k).