Over the past 20 years, 401(k) plans have become common in the American workplace, often replacing the familiar defined benefit retirement plans that used to dominate.
Simply put, a 401(k) plan is a way to encourage people to save money for retirement while at the same time lowering their state and federal taxes.
They are, explained Financial Adviser Craig Renshaw with Edward Jones, employer-sponsored tax-deferred plans.
According to the website “How Stuff Works,” this is done by deducting the amount contributed to the account from income before it is taxed, plus by deferring taxes on money earned in the plan until you are retired, at which time most people are in a lower tax bracket.
But if that is all there was to a 401(k) plan, they probably would not be as popular as they are. Most plans also include an employer contribution. And if you start early, your retirement account can accumulate an impressive sum by the time you retire.
These accounts were first authorized in 1978, but the first 401(k) plan proposal was not accepted until 1981. Taxpayers were able to take advantage of the plan in 1982. Final regulations evolved over the next 10 years and were finally published in 1991. Changes continue to come.
The name is simply the section number and paragraph of the Internal Revenue Code.
Advantages usually cited for 401(k) plans include:
•Free money from your employer.
•Lower taxable income.
•Savings and earnings that accumulate without having to remember to make deposits.
•The opportunity to retire and not have to worry about money any more.
The flip side of the coin is that the results are not guaranteed. How much money you wind up with will depend on how your investments do, as well as how much you contribute. Investment funds can lose money, as many investors found out in the recession that hit in 2008.
401(k) plans are an example of defined contribution plans. This family of plans includes profit sharing plans, Individual Retirement Accounts (IRAs), Simple IRAs, SEPs and money purchase plans.