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What is a 401k Plan?

Updated: Aug 27, 2021

A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees. It is named after a section of the U.S. Internal Revenue Code. Workers can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. In a Roth 401(k) plan, withdrawals can be tax-free.

These tax-advantaged accounts are a critical part of saving for retirement for millions of Americans. Before 401(k) plans were introduced in the early 1980s, companies often provided their employees defined benefit pension plans to provide long term retirement security.

While the 401(k) was not originally designed to replace employee pension plans, employers began phasing out their defined benefit plans over time to avoid the administrative costs and the liability burden involved. So, now the retirement savings responsibility solely onto the shoulders of employees.

Self- Directed 401(k) Plans

If you are offered the option of a self-directed 401(k) by an employer, the custodian would be the plan administrator.

The same contribution limits apply as for regular IRA and 401(k) plans. In 2020 and 2021, the maximum IRA contribution is $6,000, plus a $1,000 catch-up for those aged 50 or above. The maximum for 401(k) plans is $19,500, plus a $6,500 catch-up.

The withdrawal rules are also the same. A withdrawal made from any traditional IRA or 401(k) prior to age 59½ will trigger a 10% early-withdrawal penalty unless an exception applies.

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