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Why a 401(k) plan?

The 401(k) Plan is a tax-deferred retirement plan that is qualified under Section 401(k) of the International Revenue Code.  It has been by far the most popular type of retirement savings plan in the past several years.  In fact, virtually all Fortune 500 companies, as well as thousands of smaller employers and union groups, have established 401(k) plans.

Under a 401(k) plan, no current federal income tax is due on deferred earnings contributed to the plan.  Each employee can elect to reduce his or her wages by a certain amount, and have that amount contributed to the plan.  The deferred amount does not appear as taxable income on the employee's W-2 statement.  Thus, the contribution are not subject to current federal or state income tax until the employees receive the money from the plan.

Employees' elective contributions are subject to Social Security tax and federal unemployment tax.  However, this means that there are no reductions in benefits from these government programs due to 401(k) contributions.

Contributing money to a 401(k) plan before taxes immediately increases the amount employees can save for retirement, compared to saving with after-tax money.  For example, if an employee in the 28% tax bracket elects to defer $500 of earnings each year, his or her federal tax savings would total $140 - an actual reduction in spendable income of only $360.

Like the contributions themselves, any interest or investment growth earned on the employee's individual account is free from federal income tax until it is distributed.  Generally, distributions are available at retirement or termination in the form of a lump-sum payment.

The convenience of wage or salary reduction retirement savings through regular automatic payroll reduction makes the savings easy and routine.  Contributions are not missed because a predetermined percentage of wages is deposited into each employee's 401(k) account before the paycheck is received.

A 401(k) plan is better than an IRA because of the limitations on deductions for IRA contributions, and because employees can make a higher contribution to a 401(k) plan than to an IRA.  A 401(k) plan enables employees to contribute up to $18,000 (adjusted periodically for cost-of-living increases) in 2015 to their tax-deferred account.

Federal law governs the operation of the plan and the plan's rules for participation, timing, and amount of contributions, investment of funds, and withdrawal or distribution of benefits.