401(k) Plans

A 401(k) plan permits employees to choose to defer a portion of their wages on a pre-tax basis. The 401(k) plan must be part of a qualified profit-sharing plan, a stock bonus plan, a pre-ERISA money purchase pension plan, or a rural cooperative plan. A 401(k) plan frequently features an "employer matching" provision in which the employer makes a contribution to the plan equal to (a certain percentage of) the employee's contribution. This serves to encourage participation among employees at all levels.

The company usually offers at least four alternative investment vehicles. Because the law requires that participation in the plans not be too heavily skewed towards more highly paid people, companies generally offer a partial match to encourage broad participation in these voluntary plans. This match can be in any investment vehicle the company chooses, including company stock. There is a combined limit of taxable pay that the company and the employee together can contribute to the plan per year. This limit is further reduced by contributions to other tax-qualified retirement-oriented benefit plans.

The major benefit to employees of the 401(k) plan is that they are not taxed currently on the portion of compensation that is placed in the plan. An employee has the option of choosing between cash or future benefits on a year-to-year basis. In addition to the tax deferral, another major benefit is that a 401(k) plan is eligible for five-year averaging on distributions. But, if an early distribution is taken, the amount is subject to an additional 10 per cent tax.

Because a 401(k) plan is a qualified plan, it is subject to the same rules imposed by the Internal Revenue Code and ERISA as are all other qualified plans.

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