401(k) Plans

Also known as a cash or deferred arrangement (CODA), a 401(k) plan takes its name from section 401(k) of the Internal Revenue Code.  Section 401(k) prescribes the additional requirements applicable to such plans. A 401(k) plan is a qualified defined contribution plan in which an employer permits an employee to defer receipt of a portion of his or her compensation by contributing that portion to his or her account in the plan. Deferred employee contributions are made on a pre-tax basis, and those contributions and all earnings remain untaxed until withdrawn from the plan.

Many 401(k) plans include a matching contribution from the employer according to a set formula (e.g., 50% of the employee's contribution up to a maximum of 6% of compensation). Employers may also make contributions to an employee's account independent of the employee's contribution, and these contributions may be tied (implicitly or explicitly) to the employer’s profits as part of a profit sharing plan. In 2008, a participant's pre-tax contributions are limited to the lesser of 100% of pay or $15,500. Historically the dollar limit has increased, due to a phase-in of the limits, and since 2006 on the basis of cost-of-living adjustments.

Below is a list of the annual dollar limit for each of the following years:

The $15,500 limit will increase in $500 increments whenever the cumulative effects of cost-of-living adjustments indicate such a rise is needed.

In addition to the normal contribution limits outlined above, those participants over the age of 50 may make an additional "catch-up" contribution of $5,000.

As with the regular dollar limit the $5,000 "catch-up" limit will increase in $500 increments whenever the cumulative effects of inflation indicate such a rise is needed.

Beginning in 2006, 401(k) plans can permit participants to make contributions through those plans to a Roth-401(k) account. The decision to offer this option is entirely up to the employer. If allowed, contributions to the Roth-401(k) account will be taxed in the year made, but future qualified distributions from that account will not be taxed. Contributions to a Roth-401(k) account may be made up to the $15,500 maximum yearly limit.  Click here for a more in-depth discussion of Roth-401(k).

Many 401(k) plans offer participants an opportunity to direct the investment of their accounts.  If so, the participants should be allowed to select from a broad diversified range of investment options from conservative risk to aggressive risk. These options may include institutional or mutual funds investing in the money market, bond market, or stock market; annuities; guaranteed investment contracts (GICs); company stock; and self-directed brokerage accounts.

In general, a 401(k) plan limits withdrawals of assets to five occasions: Termination from employment, disability, reaching the age of 59 1/2, retirement, and death. Additionally, the plan may optionally include provisions for loans and/or hardship withdrawals.

State and local governments are prohibited from offering 401(k) plans to their employees.