What is a 401(k) Plan?

401(k) retirement plans are commonly offered by employers. Learn how they work.

A 401(k) plan is a type of retirement vehicle favored by many employers. Employees contribute part of their pre-tax income into the plan, where it is invested. Employees pay no income tax on their contributions or the earnings on the investments until they take money out.

How 401(k) Plans Work

Once an employer sets up a 401(k) plan, employees can defer part of their income into a 401(k) account, before tax. Some employers match all or part of employee contributions; others don't. There is an annual limit on the amount employees can contribute to a traditional 401(k). For 2011 and 2011, the limit for employees under the age of 50 is $11,500. Employees who are 50 or older may make larger deferrals, called "catch-up" contributions. For 2011 and 2012, the limit for older employees is $17,000. After 2012, these amounts will be subject to change to reflect the cost of living.

The most popular plans offer employees a range of investment options for their accounts. Neither contributions to the account nor investment earnings are taxable to the employee until the employee begins taking distributions from the plan.

Taking Money Out of a 401(k) Plan

You must pay tax on the money you take out of a 401(k) plan. If you wait until you reach the age of 59 and a half, you won't pay a penalty on withdrawals from the plan. If you are at least 55 years old and you withdraw money after you quit, are fired, or are laid off, you also won't pay a penalty. No penalty will be due if you have a qualifying disability or you die (and distributions are made to beneficiaries).

In most other situations, you will have to pay a 10% penalty if you withdraw money from your plan early. This rule is intended to encourage employees to use these plans for their retirement, not for other financial needs that might arise.

Hardship Withdrawals

Employees may take money out of a 401(k) plan if they have an "immediate and heavy" financial need. Most plans limit the amount employees can take for this purpose to the employees' own elective contributions to the plan, not any employer matching funds. Also, employees may not withdraw more than they need to handle the hardship. These hardships will entitle an employee to take this type of withdrawal:

  • medical expenses already incurred by the employee or a family member
  • home buying costs (not include mortgage payments)
  • tuition and related educational expenses for the employee or a family member
  • payments necessary to prevent eviction or foreclosure
  • certain home repair expenses, and
  • funeral expenses.

After taking a hardship withdrawal, an employee won't be allowed to defer any income to the plan for at least six months.

Employees must pay regular income tax on any amounts withdrawn for hardship, and may also have to pay the 10% penalty.

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