401K

Many people are saving for their retirement by virtue of 401k retirement plan deductions from their paychecks. A 401k plan is an employer-sponsored plan which contains what is called a "defined contribution," or a plan that provides for an individual account. The name comes from the legal definition regarding income tax rulings, found in Section 401(k) of the Internal Revenue Code.

With a 401k tax deduction, the gross taxable income is reduced on each paycheck, therefore lowering federal, state and local tax deductions and results in more net income for the taxpayer. Income taxes on the saved money and earnings are typically deferred until the funds are withdrawn. Investment options are numerous, but most concentrate on a group of mutual funds that include bonds, money market and stock investments where slow, consistent growth is the focus.

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When the U.S. Congress amended the Internal Revenue Code in 1978, the concept of the 401k account quickly become the payroll deduction and retirement plan of choice. Probably the biggest reason that 401k retirement plans got so popular so quickly was because it was cheaper for the employer to maintain compared to a defined benefit pension (or a pension plan that is not defined as a contributory plan) for retirees. Also, 401k plans create a more predictable cost for employers compared to a defined benefit retirement plan, which can vary unpredictably from year to year.

There were some changes made to the concept by the IRS along the way. Interestingly enough, when 401k retirement plans first became a reality, they were originally intended for executives only, but that was amended in 1981. In 1998, Congress altered the mechanics of 401k plans once again when they passed legislation allowing employees to contribute to their retirement by using payroll deductions. This came right off the top of their gross income, therefore lowering their tax liability. In addition, it was not mandatory that an employee contribute to their own 401k plans.

Once the employee has reached their time for retirement, they are faced with a couple of options regarding their 401k accounts. Most often, the 401K account is terminated a 401k Rollover, a process wherein the funds in the account are reinvested into another form of investment or payment structure. It can also refer to the transfer of the balance in the 401k account into another 401k plan or an IRA (Individual Retirement Account). Typically, this is one of the main alternatives that the retiree chooses.