401(k) plans must be sponsored by an employer, typically a private sector corporation, but self employed individuals can set them up also, and previously government entities could too. The employer acts as a plan fiduciary and is responsible for creating and designing the plan as well as selecting and monitoring plan investments. (In practice, nearly all employers outsource all of this work to a brokerage firm or other financial company.)

The employee asks to have a portion of his salary paid directly, or "deferred", into his 401(k) fund. In trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate his money among these investment choices at any time.

Some companies match employee contributions to some extent, paying extra money into the employee's 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing contributions into the 401(k) plan. These contributions may vest over several years as an inducement to the employee to stay with the employer.

When an employee leaves a job, he can generally keep that 401(k) account active for the rest of his life, if desired, though in 2004 some companies started charging the portion of the plan fees to ex-employees who maintained their 401(k) account with that company that the employer otherwise would have paid. Alternatively, if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can "roll over" his account into a new 401(k) account hosted by the new employer, or into an IRA.

Tax benefits and considerations
The employee does not pay taxes on the amount of income that he defers to his 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into his 401(k) account that year is taxed as though he had earned only $47,000 in that year, ignoring other deductions. In 2004, this would represent a near term $750 savings in taxes for a single worker, assuming he remained in the 25% marginal tax bracket when taking into account other deductions and adjustments.

Furthermore, all earnings from the investments in a 401(k) account are not taxed. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over the years.

The employee finally pays taxes on the money as he withdraws it after his retirement. The taxes are at the "ordinary income" rate, falling into whatever tax bracket the employee is in at the time he withdraws the money. The assumption is often made that the employee will be in a lower tax bracket in retirement, but this assumption is not always realistic or guaranteed to be correct.

The IRS allows the tax advantage for income deferred into a 401(k), but places the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59 1/2 years of age. Money that is withdrawn prior to 59 1/2 is typically assessed with a 10% penalty tax immediately unless a further exception applies.[1] This penalty is of course on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the penalty include: the employee being totally and permanently disabled, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor).

In only the last two of the above cases, it is possible for the employee to withdraw money from the plan before separation from service and avoid the penalty. One more option for withdrawal from a 401(k) while currently employed is a hardship distribution with specific hardship rules applying. Hardship withdrawals are subject to the 10% penalty if made before age 59 1/2. Plans can either offer or not offer many of the above options for withdrawal.

Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back either before separation from service or immediately upon separation.

History
The first 401(k) was created in 1980 by Theodore Benna, a consultant working for the Johnson Companies [2] (http://www.401kassociation.com/history.html)[3] (http://www.usatoday.com/money/401k019.htm). Originally intended for executives, during the decade of the 1990s the plan proved popular with workers at all levels because it offers greater flexibility than Individual Retirement Accounts (IRAs), with higher yearly contribution limits than IRAs, and the ability to "roll over" the account from job to job. Also, 401(k) plans are tax-qualified plans covered by the Employee Retirement Income Security Act of 1974 (ERISA), so assets held by the plans are protected from creditors. That protection does not apply to IRA accounts in some states.

Much of the reason for the explosion of 401(k) plans was because they are cheaper for employers than maintaining a pension for every retired worker. In most cases, defined contribution plans are less expensive than defined benefit plans for employers. 401(k) plans also create a predictable cost for employers while the cost of defined benefit plans can vary unpredictably from year-to-year.

Technical details
There is a maximum yearly employee contribution. The limit in 2004 is $13,000 for employees under the age of 50. Employees over the age of 50 are now allowed an additional "catch up" provision of up to $3,000 in 2004. If the employee somehow contributes more than the maximum to his 401(k) account, she must withdraw the excess; if this is noticed too late, the employee may have to pay taxes and penalties on the excess and move it to another type of account.

Plans set up under section 401(k) can also have employer contributions that when added to the employee contributions can add up to more than the above limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, or the lesser of the employees compensation or $40,000 for 2004.

Governmental employers in the US (that is, federal, state, county, and city governments) are currently barred from offering 401(k) plans unless they were established before May 1986. Governmental organizations instead can set up general plans qualifying under section 401(a) or a plan similar to a 401(k) set up under section 457(g).

To help ensure that companies extend their 401(k) plans to low-paid employees, an IRS rule limits the maximum deferral by the company's "highly compensated" employees, based on the average deferral by the company's non highly compensated employees. If the rank and file saves more for retirement, then the executives are allowed to save more for retirement. This provision is known as discrimination testing. There are a number of "safe harbor" provisions that can allow a company to not have to carry out the discrimination testing. The most common is the company offering a 3% non elective contribution to employees accounts.

401(k) plans for certain small businesses or sole proprietorships
Many self-employed persons felt (and financial advisors agreed) that 401(k) plans weren't in tune with their needs due to the high costs and difficult administration. But the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made 401(k) plans simpler to set up for self employed persons. While EGTRRA did not explicitly create a new type of retirement plan, it made a number of constructive changes to existing laws governing 401(k) plans.

Specifically, an employer with only employees meeting the definition of 'highly compensated' can now set up a 401(k) plan without having to carry out the expensive discrimination testing most large plans must do. The definition of highly compensated is unusual in that it takes into account not only the expected income requirement, but also includes direct family members such as the owner's spouse, children, and parents. In addition, if the plan has less than $100,000 in assets, it is exempt from filing the complicated annual 5500 tax form. The legislation thus had an unintended benefit of more easily allowing higher contribution limits for qualifying small employers. Many vendors now offer these type of plans which are often called Solo 401(k) or Individual(k) plans