401K refers to a section in the Internal Revenue Code of the Federal government aimed at encouraging workers to establish retirement savings plans. This section was established in 1981.
A 401K plan is actually a tax deferred investment and savings plan. Under this plan, an employee of a corporation or a private company is allowed to save and invest money for retirement purpose. A 401K Plan thus acts as a personal pension fund for employees of corporations and private companies. In a 401K plan an employee authorizes the employer for pre-tax payroll deductions from a salary. These deductions are invested in various investment options including mutual funds. These options could differ for company to company. Under this plan the investment earnings and the employees’ contributions continue to grow. They are taxed as ordinary income at the time of withdrawal, which is assumed to be at retirement. Till then both the investments and contributions continue to grow tax-deferred.
It is a very simple concept. A 401K plan is set up by the employer. The employee has to decide what percentage should be deducted from the income before his or her paycheck is taxed. That means it is the employee who pays into the plan. But once an employee decides then the rest of the things are taken care of by the employer and the plan provider. The contribution to this plan is automatically deducted from the pay of the employee in each pay period. This money is then invested before the employee’s income has been taxed. The money continues to grow in your personal 401K account. The money can be withdrawn in case of certain emergencies. In some cases one can borrow against it also. But generally the money is supposed to stay in an employee’s account till he or she attains the age of 591/2 years.
