Qualified cash or deferred arrangements (CODAs) permitted under Section 401(k) of the Internal Revenue Code, commonly referred to as “401(k) plans,” have become one of the most popular types of employer-sponsored retirement plans.
How does a 401(k) plan work?
With a 401(k) plan, you elect either to receive cash payments (wages) from your employer immediately, or defer receipt of a portion of that income to the plan. The amount you defer (called an “elective deferral” or “pre-tax contribution”) isn’t currently included in your income; it’s made with pre-tax dollars. Consequently, your federal taxable income (and federal income tax) that year is reduced. And the deferred portion (along with any investment earnings) isn’t taxed to you until you receive payments from the plan.
Example: Melissa earns $30,000 annually. She contributes $4,500 of her pay to her employer’s 401(k) plan on a pre-tax basis. As a result, Melissa’s taxable income is $25,500. She isn’t taxed on the deferred money ($4,500), or any investment earnings, until she receives a distribution from the plan.
You may also be able to make Roth contributions to your 401(k) plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pre-tax contributions to a 401(k) plan, there’s no up-front tax benefit, but qualified distributions from a Roth 401(k) account are entirely free from federal income tax.