What is a 401(k)?
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Q:

What is a 401(k)?

A:

Quick Answer

The government offers taxpayers the 401(k) as a retirement savings plan sponsored by their employer. Using this program, workers are able to save and invest a portion of their paycheck before the employer withholds taxes. According to The Wall Street Journal, the employer matches a certain percentage of the savings invested by the employee.

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Full Answer

The 401(k) plan receives its name from the section and paragraph numbers in the Internal Revenue Code. Congress passed the Tax Reform Act in 1978, including the tax-deferred savings plan, as an incentive to encourage citizens to save for retirement and lower their taxes, according to HowStuffWorks.

While a traditional 401(k) plan offers tax deferment, allowing the individual to wait to pay taxes until the investor withdraws the money, the Roth 401(k) plan does not defer taxes. The advantage of the traditional plan is that the investor pays taxes after retirement, when supposedly his income is lower. With the Roth plan, the earnings on the investment are tax deferred until retirement, and in many cases, investors pay no taxes on these earnings, according to Wikipedia.

To discourage citizens from making early withdrawals of funds from their 401(k) plan, there is a 10 percent penalty for early withdrawals. Wikipedia reminds employees that since most employers require them to withdraw money when changing jobs, the government provides a chance to "roll over" their savings into another qualified plan to avoid this penalty.

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