The Revenue Act of 1978 added Section 401(k) to the Internal Revenue Code and, since then, the growth of these tax-deferred savings plans has been dramatic.
The basic idea of a 401(k) is simple: it is a profit sharing plan adopted by an employer that permits employees to set aside a portion of their compensation through payroll deduction for retirement savings. The amounts set aside are not taxed to the employee and are a tax deductible business expense for the employer.
An employer's discretionary matching contribution can provide incentive for employee participation as well as serve as an employee benefit. The employer can match any percentage of the employees' contributions. Employer contributions can be capped, to limit costs, and a vesting schedule can be applied to employer deposits (employees are always 100 percent vested in their own contributions).
For employees, the opportunity to reduce federal -- and often state and local -- taxes through participation in a 401(k) plan offers significant benefits. While savings are intended for retirement, certain types of loans can provide employees with access to their funds -- employees repay borrowed principal plus interest to their own account. From an employer's standpoint, the 401(k) can be the least expensive and most flexible of all retirement plans.
Special nondiscrimination tests apply to 401(k) plans, which may limit the amount of deferrals that highly compensated employees are allowed to make. As a result, a minimal employer contribution may be required.
