What is a 401(k) plan?

A 401(k) plan is named for the Internal Revenue Code section that governs the plan. Under a 401(k) plan (also known as a "cash or deferred arrangement" or a "salary reduction plan"), an employee may elect to defer current taxation on a portion of salary by having their employer contribute a limited portion to a qualified plan on behalf of the employee. An employer may further enhance an employee's account by making a contribution that matches all or a portion of the employee's elective deferral.

Such an arrangement must be part of a profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural electric or telephone cooperative plan.

The employee is not subject to current income tax on the amount of the elective deferral or on the employer's matching contribution. The employee is not taxed on amounts in the account until they are distributed, at which time the employee may be in a lower tax bracket.

A 401(k) plan participant has a nonforfeitable right to elective deferrals once they are made. However, an employee's right to a distribution from the account prior to retirement or the termination of employment is limited.

401(k) plans are subject to the rules that generally apply to qualified plans. However, 401(k) plans must also comply with additional requirements that are primarily designed to assure that the plan does not discriminate in favor of highly compensated employees as to plan coverage or as to contributions and benefits.

Reprinted with permission. © CCH