What Is A 401k Plan?

Internal Revenue Code section 401(k) was introduced as part of the Revenue Act of 1978. Commonly known as “401(k) plans,” these kinds of plans first came into prominence in the early 1980s. Section 401(k) defines a feature of a defined contribution plan that allows employees to choose to defer some income (and, consequently, defer current taxation of that income) into a retirement account.

In general, defined contribution plans are individual accounts that accumulate employer and employee contributions, plus earnings, the result of which is available to the employee at retirement. The most prevalent 401(k) plan is known as a savings and thrift plan (or some variant such as a thrift-savings plan), which gives the employee the option to invest some percent of earnings that is then matched by employer funds. For example, a plan might allow the employee to contribute from 1-10 percent of their earnings, tax deferred, with the employer matching 50 percent of the first 6 percent of earnings contributed. If the employee chose to contribute 10 percent, the employer would add 3 percent (50 percent of the first 6 percent). The total of 13 percent of earnings would then be invested in the employee’s account.

There are other types of defined contribution plans and other ways that section 401(k) is used to allow pretax contributions. In all cases, the total employee and employer contributions are invested, with the employee bearing the risk of investment gains and losses.