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The plan is named for the section of the IRS code , which lays out the rules for employer sponsored retirement plans. 401(k) plans are designed to allow employees to defer money from their pay check on a pre-tax basis to save towards retirement. Under recent laws employees can also make ROTH 401(k) contributions which are taxed upfront but then not subject to taxation upon withdrawal at retirement.
Often the employer also makes a matching contribution to the employees account which is typically based upon the amount the employee contributes. This can be set up as a dollar for dollar match up to a certain amount or as a percentage of the employee’s income.
The money that an employees defers from their paycheck is always owned 100% by the employee. The employer matching portion is instead typically subject to a vesting schedule. This may require that an employee remained employed for a specific amount of time (typically 5 years) before the employer contribution portion is 100% owned by the employee. If the employer were to leave prior to the end of the specified term then would then only own a portion of what the employer has contributed to their 401k account.
The employee portions of the deferrals are not subject to income tax only social security and Medicare taxes. The employer match portion is not subject to any taxes.
There are also limits to the amount of contributions that can be made into a 401 (k) Plan on an annual basis. For 2013 this is $17,500 unless you are age 50 and over where as you can contribute an additional $5,500.
The maximum any employee can defer is 100% of their salary so if an employee earns less than the $17,500 a year. These limits are based on the employee’s salary and if the salary is less than the maximums listed above then they would only be able to defer up to their salary amount.
Stay tuned for next weeks blog which will review what the options are within a 401(k) Plan.