History

• 401(k) plans were first introduced as part of the Revenue Act of 1978, which permitted for-profit employers to set up salary deferral retirement plans for their employees. The Tax Reform Act of 1986 reduced the amount of money that could be deferred from $30,000 per year to just $7,000 per year (to be adjusted for inflation in future years) and also made the plans more equitable among all employees rather than allowing plans to be geared towards primarily benefiting higher-paid employees.
  
  

Taxation of Contributions

• Contributions to 401(k) plans are made with pretax dollars, which means that the money is not included as taxable income on your W-2 form. For example, if you make $69,000 but contributed $4,000 to your 401(k) plan, your W-2 would only show $65,000 of income subject to income taxes. Contributions your employer makes on your behalf are also made with pretax dollars. Once the money is in the account, it grows tax-free as long as it stay in the 401(k) plan.
  
  

Taxes on Distributions

• When you take money out of your 401(k) plan at retirement, the amount of your distribution is included in your taxable income. The tax rate will depend on your total income for the year. For example, if your total income puts you in the 30 percent income tax bracket, your 401(k) plan distribution amount is taxed at 30 percent.
  
  

Early Withdrawal Penalties

• 401(k) plans typically do not allow you to take withdrawals before reaching age 59 1/2. However, you can withdraw funds in the event of a financial hardship, such as needing money to avoid being evicted from your primary residence, if you have no other resources to pay. Withdrawals before age 59 1/2 are subject to a 10 percent early withdrawal penalty on top of the taxes that you will owe.
  
  

Misconceptions

• Contributions made to a 401(k) plan by an employee are not included as wages subject to income tax. However, the money is still subject to payroll taxes, which include the Social Security tax and the Medicare tax. For example, in 2010 the payroll tax rate on employee earnings is 7.65 percent so if you contributed $500 to your 401(k) plan, you would not have to pay income taxes on the $500 but your employer would still take out $38.25 from your paycheck for payroll taxes.