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What is a 401k?

By FinanceBuddy Staff Writer

In the United States of America, a 401(k) plan allows a worker to save for retirement and have the savings invested while deferring income taxes on the saved money and earnings until withdrawal.

The employee elects to have a portion of his or her wages paid directly, or "deferred," into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stock, bonds, money market investments or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock.

The employee can generally re-allocate money among these investment choices at any time. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.

Some assets in 401(k) plans are tax deferred. Before the January 1, 2006, effective date of the designated Roth account provisions, all 401(k) contributions were on a pre-tax basis (i.e., no income tax is withheld on the income in the year it is contributed), and the contributions and growth on them are not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k).

Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed).

In addition to Roth and pre-tax contributions, some participants may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax basis and may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account is taxed as ordinary income.