What is a 401(k) plan? 

A 401(k) plan is an employer-sponsored, personal pension (savings) account, provided by numerous American employers, offering tax benefits to participants. It’s named after a section of the U.S. Internal Revenue Code (IRC).  

As an employee when you sign up for your employer’s 401(k) plan, you agree to have a percentage of each paycheck directly deposited into your own personal 401(k) account. The employer may match part or all of that contribution. 

How 401(k) works 

Originally the 401(k) plan was designed to encourage Americans to save up for their retirement. The first implementation of the 401(k) plan was in 1978. Since then, employees and employers have most commonly used two types of account available: a traditional 401(k) and a Roth 401(k).  

Currently, there’s no federal legislation requiring any employer to offer a retirement plan. However, since 2012, 46 states have either implemented a state-based retirement savings program, or considered legislation in order to encourage people to save for their future. 

Traditional 401(k) vs. Roth 401(k) 

The main difference comes down to when employees pay taxes on their contributions, which may impact the match employers can make.  

With a traditional 401(k) plan, contributions are taken out of an employee’s paycheck before income taxes are calculated. Therefore, contributions help lower taxable income for the employee immediately.  

The funds are invested in mutual funds and other investments, and grow in value over time. When you withdraw money out of your traditional 401(k) in retirement, you pay ordinary income tax on the withdrawals. 

With a Roth 401(k), contributions are made after income taxes have been applied. Similar to a Roth IRA you pay no taxes on qualified distributions, for example, those made after the age of 59 ½ – assuming your first contribution was made five years prior. 

Automatic enrollment  

A 401(k) plan can have an automatic enrollment feature. This permits the employer to automatically reduce the employee’s wages by a fixed percentage or amount and contribute that amount to the 401(k) plan unless the employee has chosen not to have their wages reduced/chosen a different percentage. These contributions qualify as elective deferrals. 

If you’re in the process of setting up a 401(k) plan for your employees, the IRS has a step-by-step guide.