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In the United States, a 401(k) plan is the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the Internal Revenue Code.[1] Under the plan, retirement savings contributions are provided (and sometimes proportionately matched) by an employer, deducted from the employee’s paycheck before taxation (therefore tax-deferred until withdrawn after retirement or as otherwise permitted by applicable law), and limited to a maximum pre-tax annual contribution of $19,000 (as of 2019).[2][3]

Other employer-provided defined-contribution plans include 403(b) plans for nonprofit institutions, 457(b) plans for governmental employers, and 401(a) plans. These plans may provide total annual addition of $55,000 (as of 2018) per plan participant, including both employee and employer contributions.


In the early 1970s, a group of high-earning individuals from Kodak approached Congress to allow a part of their salary to be invested in the stock market and thus be exempt from income taxes.[4] This resulted in section 401(k) being inserted in the then taxation regulations that allowed this to be done. The section of the Internal Revenue Code that made such 401(k) plans possible was enacted into law in 1978.[5] It was intended to allow taxpayers a break on taxes on deferred income. In 1980, a benefits consultant and attorney named Ted Benna took note of the previously obscure provision and figured out that it could be used to create a simple, tax-advantaged way to save for retirement. The client for whom he was working at the time chose not to create a 401(k) plan.[6] He later went on to install the first 401(k) plan at his own employer, the Johnson Companies[7] (today doing business as Johnson Kendall & Johnson).[8] At the time, employees could contribute 25% of their salary, up to $30,000 per year, to their employer’s 401(k) plan.[9]


Income taxes on pre-tax contributions and investment earnings in the form of interest and dividends are tax deferred. The ability to defer income taxes to a period where one’s tax rates may be lower is a potential benefit of the 401(k) plan. The ability to defer income taxes has no benefit when the participant is subject to the same tax rates in retirement as when the original contributions were made or interest and dividends earned. Earnings from investments in a 401(k) account in the form of capital gains are not subject to capital gains taxes. This ability to avoid this second level of tax is a primary benefit of the 401(k) plan. Relative to investing outside of 401(k) plans, more income tax is paid but less taxes are paid overall with the 401(k) due to the ability to avoid taxes on capital gains.

For pre-tax contributions, the employee does not pay federal income tax on the amount of current income he or she defers to a 401(k) account, but does still pay the total 7.65% payroll taxes (social security and medicare). For example, a worker who otherwise earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only reports $47,000 in income on that year’s tax return. Currently this would represent a near-term $660 saving in taxes for a single worker, assuming the worker remained in the 22% marginal tax bracket and there were no other adjustments (like deductions). The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement. The character of any gains (including tax-favored capital gains) is transformed into “ordinary income” at the time the money is withdrawn.

Beginning in the 2006 tax year, employees have been allowed to designate contributions as a Roth 401(k) deferral. Similar to the provisions of a Roth IRA, these contributions are made on an after-tax basis.

If the employee made after-tax contributions to the non-Roth 401(k) account, these amounts are commingled with the pre-tax funds and simply add to the non-Roth 401(k) basis. When distributions are made the taxable portion of the distribution will be calculated as the ratio of the non-Roth contributions to the total 401(k) basis. The remainder of the distribution is tax-free and not included in gross income for the year.

For accumulated after-tax contributions and earnings in a designated Roth account (Roth 401(k)), “qualified distributions” can be made tax-free. To qualify, distributions must be made more than 5 years after the first designated Roth contributions and not before the year in which the account owner turns age 59, unless an exception applies as detailed in IRS code section 72(t). In the case of designated Roth contributions, the contributions being made on an after-tax basis means that the taxable income in the year of contribution is not decreased as it is with pre-tax contributions. Roth contributions are irrevocable and cannot be converted to pre-tax contributions at a later date. (In contrast to Roth individual retirement accounts (IRAs), where Roth contributions may be re characterized as pre-tax contributions.) Administratively, Roth contributions must be made to a separate account, and records must be kept that distinguish the amount of contribution and the corresponding earnings that are to receive Roth treatment.

Unlike the Roth IRA, there is no upper income limit capping eligibility for Roth 401(k) contributions. Individuals who find themselves disqualified from a Roth IRA may contribute to their Roth 401(k). Individuals who qualify for both can contribute the maximum statutory amounts into either or a combination of the two plans (including both catch-up contributions if applicable). Aggregate statutory annual limits set by the IRS will apply.[10]

Withdrawal of funds

Generally, a 401k participant may begin to withdraw money from his or her plan after reaching the age of 59 without penalty. The Internal Revenue Code imposes severe restrictions on withdrawals of tax-deferred or Roth contributions while a person remains in service with the company and is under the age of 59. Any withdrawal that is permitted before the age of 59 is subject to an excise tax equal to ten percent of the amount distributed (on top of the ordinary income tax that has to be paid), including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).[11] Amounts withdrawn are subject to ordinary income taxes to the participant.

The Internal Revenue Code generally defines a hardship as any of the following.[12]

  • Unreimbursed medical expenses for the participant, the participant’s spouse, or the participant’s dependent.
  • Purchase of principal residence for the participant.
  • Payment of college tuition and related educational costs such as room and board for the next 12 months for the participant, the participant’s spouse or dependents, or children who are no longer dependents.
  • Payments necessary to prevent foreclosure or eviction from the participant’s principal residence.
  • Funeral and burial expenses.
  • Repairs to damage of participant’s principal residence.

Some employers may disallow one, several, or all of the previous hardship causes. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59 years of age. Money that is withdrawn prior to the age of 59 typically incurs a 10% penalty tax unless a further exception applies.[13] This penalty is on top of the “ordinary income” tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee’s death, the employee’s total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor). This does not apply to the similar 457 plan.

Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at predefined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a “reasonable” rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan’s loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in “default”. A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.

These loans have been described[by whom?] as tax-disadvantaged, on the theory that the 401(k) contains before-tax dollars, but the loan is repaid with after-tax dollars. While this is precisely correct, the analysis is fundamentally flawed with regard to the loan principal amounts. From your perspective as the borrower, this is identical to a standard loan where you are not taxed when you get the loan, but you have to pay it back with taxed dollars. However, the interest portion of the loan repayments, which are essentially additional contributions to the 401(k), are made with after-tax funds but they do not increase the after-tax basis in the 401(k). Therefore, upon distribution/conversion of those funds the owner will have to pay taxes on those funds a second time.[14]

Required minimum distributions (RMD)

Account owners must begin making distributions from their accounts by April 1 of the calendar year after turning age 70 or April 1 of the calendar year after retiring, whichever is later. The amount of distributions is based on life expectancy according to the relevant factors from the appropriate IRS tables.[15] There is an exception to minimum distribution for people still working once they reach that age. The exception only applies to the current plan they are participating in and does not apply if the account owner is a 5% owner of the business sponsoring the retirement plan.[16] Required minimum distributions apply to both pretax and after-tax Roth contributions. Only a Roth IRA is not subject to minimum distribution rules. Other than the exception for continuing to work after age 70 differs from the rules for IRA minimum distributions. The same penalty applies to the failure to make the minimum distribution. The penalty is 50% of the amount that should have been distributed, one of the most severe penalties the IRS applies. In response to the economic crisis, Congress suspended the RMD requirement for 2009.

Required distributions for some former employees

A 401(k) plan may have a provision in its plan documents to close the account of a former employee who have low account balances. Almost 90% of 401(k) plans have such a provision.[17] As of March 2005, a 401(k) plan may require the closing of a former employee’s account if and only if the former employee’s account has less than $1,000 of vested assets.

When a former employee’s account is closed, the former employee can either rollover the funds to an Individual Retirement Account, rollover the funds to another 401(k) plan, or receive a cash distribution, less required income taxes and possibly a penalty for a cash withdrawal before the age of 59.

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