There's much to be said about 401(k) plans, whether adminsitering one or participating in one. This article deals with some of both. If your questions are not answered here, try our links and resources page. As a legislative changes occur, these plan rules are subject to change as well.
401(k) plans are known as defined contribution plans. Defined contribution plans are so named because the amount that is contributedto the plan is defined either by the employee (a.k.a. the participant) or the employer.
In 1978, Congress determined that Americans needed encouragement to save more money for retirement. As a result, they gave employers a way to offer an employee benefit - to save for retirement while at the same time lowering their state and federal taxes. The Tax Reform Act was passed. Part of the act authorized the creation of a tax-deferred savings plan for employees of for-profit organizations. The 401k got its name from its section and paragraph number / letter in the Internal Revenue Code (IRC) -- section 401, paragraph k.
A benefits consultant named Ted Benna, came up with the first iteration of the 401k plan. His plan was accepted by the IRS and proposed regulations were issued in 1981. Taxpayers were able to take advantage of this new plan for the first time in 1982. Nearly 10 years later in 1991, final regulations were published.
401k's must be sponsored by an employer, generally a private sector corporation (Though non-governmental tax-exempt organizations may set up 401k plans as well). A self-employed individual can set up an individual 401(k) plan (also known as a solo 401k). The employer acts as a fiduciary and is responsible for creating and designing the plan, as well as selecting and monitoring the investments available in the plan. Often, employers will hire financial services companies and third party adminstrators to assist with this, though the fiduciary responsibility will ultimately rest upon the employer.
The employee makes an election (also known as "contribution" or "deferral") from their gross wages. This contribution is made pre-tax so more employee dollars go to work in the selected investment(s). In trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested. More commonly, in participant-directed plans, the employee can select from a number of investment options. These investments are most often mutual fund or annuity based, generally an assortment of mutual funds or separate accounts containing stock, bond, money market investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock though more recently, limitations on the amount of employer stock have been implemented.. The employee can generally re-allocate money among these investment choices at any time.
A 401(k) plan is technically a type of profit sharing plan with a qualified Cash or Deferred Arrangement (CODA) and differs from a traditional pension plan (defined benefit plan) since contributions are voluntary and neither benefits nor contributions are defined. Although profit sharing plans are not pension plans, they and defined contribution plans are both individual account plans because each participant's benefit is the value of an individual account.