A section 401(k) plan is a type of deferred compensation plan that permits an employee to have his employer set aside a portion of his or her wages in the plan on a pre-tax basis. Upon making an election to participate in a 401(k) plan, the contributed wages are not subject to income tax withholding at the time of the deferral. Thus, they are not taxable wages at that time. However, they are subject to Social Security, Medicare, and federal unemployment taxes.

An employee is not permitted to contribute an unlimited amount to a 401(k) plan. The tax laws set the contribution amounts, and they are indexed for inflation. All contributions to retirement plans, including deferred compensation plans, are subject to additional limitations.

Usually, a 401(k) plan benefits both employees and owner/managers. However, an employer may exclude employees who are under the age of 21, who have not yet completed a year of service, or who are covered by a collective bargaining agreement that does not provide for participation in the plan. An employer is not permitted to exclude employees from a 401(k) plan simply because they are older employees.

Employers are not required to contribute to 401(k) plans. Depending on whether the plan is traditional, SIMPLE, or safe harbor, the funds contributed by an employer may or may not be forfeited if the employee leaves before a set time. On the other hand, no matter what type of 401(k) plan is established, the contributions made by the employee are always 100 percent vested immediately. When the employee leaves the job, he or she is entitled to the deferred wages he has contributed plus or minus any investment gains or losses on the deferrals.

The benefits that a participant is entitled to depend upon his account at the time of the distribution. When a participant is eligible for a distribution, he may elect to take a lump-sum distribution, to roll over the account into an Individual Retirement Account or another employer's retirement plan, or to purchase an annuity.

Many 401(k) plans permit employees to make a hardship withdrawal on account of immediate and heavy financial needs. The amount of a hardship distribution is limited, however, to the amount of the employee's elective deferral, and it does not include any income earned on the deferred amounts.

Distributions before the age of 59-1/2 are subject to an early distribution penalty of 10 percent additional tax unless an exception applies.

Copyright 2010 LexisNexis, a division of Reed Elsevier Inc.