A 401k account is a type of retirement plan that is sponsored by companies. Employees are able to contribute to the plan with pre-tax earnings. The money then grows in an account designated specifically for that employee until the employee retires or leaves the company through other means such as layoffs or voluntarily quitting.
The contributions to a 401k account are typically invested in mutual funds or treasury bonds and most companies allow the employee to choose from several different funds based on their investment personality. Investment personality is how willing the employee is to take risks. Higher-yielding funds often come with higher risk of loss.
Though each company differs slightly, the basic procedure is to offer full-time employees the option of participating in the 401k account plan. Some companies also offer a company match in which for every dollar or percentage of income the employee contributes to his or her 401k, the company matches. The employee's 401k savings increase at a faster rate when the company match is included, and many companies allow the match to be considered 100 percent vested at the time of the contribution.
Vested refers to how much of the company contribution is automatically the employee's. Some companies require the company match to stay in the 401k account for a certain period of time, such as five years, before the contribution is fully vested. If the employee leaves before the five-year period is up, only the employee contribution can be transferred. The company contribution reverts back to the company.
There are also contribution limits each year set by the Internal Revenue Service (IRS). The contribution limit is the maximum amount an employee can put into his or her 401k retirement plan. Any amount over the contribution limit is not tax-deferred. This means the overage amount will be taxed as regular income.
For employees over the age of 50, additional contributions over the contribution limit can be made. These contributions, known as "catch up contributions," are intended to help employees reaching retirement age maximize their investments. By adding more than the contribution limit to their 401k account, these older employees still have a chance to earn interest and increase the amount of money they will have for retirement.
Employees under the age of 59 1/2 are not allowed to make a 401k account withdrawal without the possibility of an early withdrawal penalty. This penalty, which is imposed by the IRS, is equal to 10 percent of the amount withdrawn. There are only a few instances where the penalty will not be assessed. Those include down payments for a house and significant medical bills. These types of early withdrawals are known as financial hardships and are only allowed in rare instances.