What is a 401(k)?
A 401(k) is an employer sponsored retirement program named after the IRS regulations which govern their operation. 401(k) plans are actually savings plans with a cash or deferred arrangement (CODA) which allows each employee to contribute money from their pay on a pre-tax basis to save towards retirement. The employer can also make contributions to the plan on behalf of the employees in the form of an employer matching allocation to supplement the salary deferrals.

Why do employers start 401(k) plans?
Employers want to attract and retain valuable employees and a 401(k) plan is a very popular and visible employee benefit. They also want to provide their workers with an effective way to save towards retirement.

Who can establish a 401(k)?
A 401(k) can be established by any sole proprietor, partnership, corporation or non-profit organization that has employees.

Do all of the employees have to be included in the plan?
Generally, all employees must be eligible to participate in the plan. However, you may set eligibility restrictions requiring an employee to complete one year of service and reach age 21 before they can enter the plan. For eligibility purposes, one year of service can be defined as working 1000 hours within a 12 month period, so it is possible to exclude some part-time employees from participation in the plan. Additionally, employees covered under a collective bargaining agreement and certain non-resident aliens may also be excluded from the plan. It is possible to exclude certain other classes of employees; however, strict IRS regulations must be met to accomplish this.

Does everyone have to participate?
No. However, there are regulations known as 401(k) non-discrimination testing that limits how much certain "highly compensated" employees can contribute to the plan based on the average participation rate of the other employees.

Is matching required?
No, but many companies choose to contribute to the plan to encourage plan participation, to stay competitive with other employers and to retain employees by making sure that talented people think of their companies as good places to work.

What is vesting?
Vesting is the process by which an employee becomes entitled to their accrued benefits in the plan. Under a 401(k) plan, employees are always 100% vested in these salary reduction contributions. However, the employer may impose a vesting schedule on employer contributions so the participant is not entitled to receive those contributions until a certain number of years of employment have passed.

How much can an employee contribute to a 401(k)?
UPDATE FOR 2005 and Catch up contribution. Generally plans do not limit on percentage basis As long as it does not exceed federal tax law limits. Most plans allow you to contribute a specific percentage of your pay -- it can typically range from 1%-15% of salary -- up to a government-imposed dollar ceiling. In 2005 the legal limit for pre-tax contributions is $14,000. There are also limits on total contributions to all your employer-sponsored retirement plans. Total contributions that you and your employer make to the 401(k) plan and to any other retirement plans the company offers cannot be more than 100% of your taxable income or $42,000, whichever is less. Update for recent tax law updates.

What is discrimination testing?
Certain "highly compensated" employees are limited in what they can contribute to a 401(k) plan based on the average participation rate of the other eligible employees at a company. To determine the allowable percentage for highly compensated employees, the plan must be tested at least annually.

Do employees pay taxes at all on the money contributed to the plan?
Yes. To avoid having your Social Security benefits affected by plan participation, salary deferral contributions are not exempt from Social Security taxes. 401(k) contributions are exempt from federal income tax and state income tax in most states. Some states, such as Pennsylvania, do collect state income taxes on the contributions. They are also exempt from local taxes in many municipalities. Employer contributions and employer paid expenses are deductible business expenses.

What happens to the money put into a 401(k) plan?
The money contributed to a 401(k) plan is transferred to a trust, to be invested as the law and plan rules direct. Although there is no legal requirement, many plans allow participants to direct their accounts among a selection of investment options.

How many investment options must be offered in a 401(k) plan?
There is no legal requirement that a 401(k) plan has to offer a specific number of investments. The Department of Labor has issued voluntary regulatory guidelines to help employers choose the investment menu they offer. These guidelines, referred to as 404(c) regulations, recommend that employers offer at least three distinct investment choices with notably different risk reward characteristics. Many plans offer more than three options even if they choose not to adopt the 404(c) guidelines.

How do participants get money out of the plan?
There are four distribution events common to all plans (retirement, separation from service, death and permanent disability). In these situations you or your beneficiary can receive distributions from the plan. Many plans have additional means to receive funds such as loan provisions, hardship withdrawals and age 59 ½ in-service distributions. You should be aware that there are restrictions and/or tax consequences for most distributions.