In a traditional 401(k) plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called "elective deferrals".
If you decide to contribute to your 401(k) plan, you have further options. You can contribute a percentage of each employee’s compensation for allocation to the employee’s account (called a nonelective contribution), or you can match the amount your employees decide to contribute, or you can do both (within the limits of the current tax law).
For example, you may decide to add a percentage — say, 50 percent — to an employee’s contribution, which results in a 50-cent increase for every dollar the employee sets aside. Using a matching contribution formula will provide additional employer contributions only to employees who make deferrals to the 401(k) plan.
If you choose to make nonelective contributions, the employer makes a contribution for each eligible participant, whether or not the participant decides to make a salary deferral to his or her 401(k) plan account.
That is, an employee's elective deferral funds (for tax-year 2012 up to $17,000 per tax year for those under age 50 and $22,500 for those over) are set aside by the employer in a special account where the funds are allowed to be invested in various options made available in the plan.
Employers may also add funds to the account by contributing matching funds on a fractional formula basis (e.g., matching funds might be added at the rate of 50% of employees' elective deferrals), or on a set percentage basis.
Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59-and-a-half, they may begin to receive "qualified distributions" from the funds in the account; these distributions are then taxed at ordinary income tax rates.
Exceptions exist to allow distribution of funds before 59 and a half. Substantially equal periodic payments, disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).
Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement (IRA).
In contrast to the 401k plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59 and a half.
The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2008, individuals are limited to contributing no more than $5,000 to a Roth IRA, if under age 50, and $6,000, if age 50 or older.
Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly).
Search for 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.
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