Legal Definitions - 401(k)

A 401(k) refers to a specific section of the U.S. Internal Revenue Code that authorizes a popular type of employer-sponsored retirement savings plan. It allows employees to contribute a portion of their pre-tax salary to an investment account, where the money grows tax-deferred until retirement. This means that contributions are deducted from an employee's gross pay before taxes are calculated, reducing their current taxable income. Any investment earnings within the 401(k) account are also not taxed until the funds are withdrawn, typically during retirement.

Many employers enhance these plans by offering matching contributions, where they contribute a certain amount to an employee's 401(k) based on the employee's own contributions. Employees usually have a selection of investment options provided by their employer. Funds can generally be withdrawn without penalty starting at age 59½, though exceptions exist for certain circumstances like disability. Early withdrawals typically incur a 10% penalty in addition to regular income taxes. Once an individual reaches a certain age (currently 73), they are usually required to begin taking minimum distributions from their 401(k) account.

Here are some examples illustrating how a 401(k) works:

• Example 1: A Young Professional Starting Out
  Scenario: Elena, a 28-year-old software engineer, starts her first job at Tech Innovations Inc. Her employer offers a 401(k) plan and matches 100% of employee contributions up to 5% of their salary. Elena decides to contribute 6% of her $70,000 annual salary to her 401(k).

  Illustration: Each pay period, 6% of Elena's salary ($4,200 annually) is deducted from her paycheck *before* income taxes are calculated. This reduces her taxable income for the year. Tech Innovations Inc. then contributes an additional 5% of her salary ($3,500 annually) to her 401(k) account as a matching contribution. Both Elena's contributions and the employer match, along with any investment growth, accumulate tax-free until she retires and begins withdrawing the funds. This demonstrates the pre-tax contribution benefit and the advantage of employer matching.

• Example 2: A Mid-Career Employee Maximizing Savings
  Scenario: Mark, a 55-year-old marketing director, has been diligently contributing to his 401(k) for years. Recognizing he is closer to retirement, he decides to take advantage of "catch-up" contributions allowed for individuals aged 50 and over, contributing the maximum allowed amount for his age group.

  Illustration: Mark's ability to make additional "catch-up" contributions beyond the standard limit allows him to accelerate his retirement savings in the years leading up to retirement. These extra contributions, like his regular ones, are also made on a pre-tax basis, further reducing his current taxable income during his peak earning years. The funds continue to grow tax-deferred, providing a substantial nest egg when he eventually retires and begins taking distributions.

• Example 3: Managing a 401(k) After a Job Change
  Scenario: Sarah leaves her job at a manufacturing company to start a new role at a consulting firm. She had accumulated a significant balance in her 401(k) from her previous employer.

  Illustration: Sarah has several options for her old 401(k) balance. She can leave it with her former employer (if permitted), roll it over into an Individual Retirement Account (IRA), or roll it into her new employer's 401(k) plan. By choosing to roll over her funds into either an IRA or her new 401(k), she avoids immediate taxes and penalties, ensuring her retirement savings continue to grow tax-deferred without interruption. This highlights the portability of 401(k) assets and the ability to maintain their tax-advantaged status even when changing employment.