Subsection (k) of Section 401 of the Internal Revenue Code provides for an employer-sponsored pension account as a benefit of employment. This plan allows for employee-investors to enjoy, with or without matching employer contributions, tax-free profits in retirement. As you might guess from a tax code that has at least 401 sections, there some additional wrinkles to the 401(k), such as the different types of 401(k) plans that employers and employees can select.
Traditional 401(k)
This is the basic employer-sponsored retirement plan. Under a traditional 401(k), employees make tax-deferred contributions to a pension plan that invests in a variety of sanctioned avenues—traditionally, stocks, bonds, mutual funds, and the money market. After age 59 ½, participants may begin to make withdrawals, which are taxed as income. Prior to this point, such withdrawals will carry an onerous penalty unless the participant can successfully claim hardship. Employers have the option of offering matching contributions to 401(k)s.
Roth 401(k)
In the same manner as the Roth IRA, which inverts the traditional IRA structure by contributing after-tax dollars for untaxed distributions, a Roth 401(k) exchanges write-offs at tax time for avoiding income and capital gains taxes in retirement. Introduced for the 2006 fiscal year, this plan is advantageous for young upstarts who are betting on themselves and their ability to earn more later in life—in the meantime, it’s better to pay the taxes now before moving up to a higher bracket. Employers can offer both traditional and Roth 401(k) plans, and employees can diversify by investing in both plans—the best of both worlds for workers.
Solo 401(k)
You don’t need to be a big business to operate a 401(k). You don’t even have to be a good-sized small business. Even sole proprietors can set up a 401(k) under what’s referred to as a solo 401(k). Among the different types of 401(k) plans, this self-employed option was designed for business owners who have no employees other than their spouses, allowing them to save for retirement while operating their own business. If a small business has several partners but no subordinate employees, they may be eligible for a solo 401(k) and its benefits.
