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In 2006, the U.S. Government instituted the Roth 401(k), which allows post-tax contributions in return for tax-free withdrawals after retirement. This gave retirement investors a wider range of choice based upon their specific needs.
Most 401(k)s are employee benefits and workers must have a sponsoring employer to take advantage of one. However, a self-employed person may also set up a 401(k) for himself/herself.
You participate in a 401(k) retirement savings plan by deferring part of your salary into an account set up in your name. Any earnings in the account are federal income tax deferred.
If you change jobs, 401(k) plans are portable, which means that you can move your accumulated assets to a new employer's plan, if the plan allows transfers, or to a rollover IRA.
With a traditional 401(k), you defer pretax income, which reduces the income tax you owe in the year you made the contribution. You pay tax on all withdrawals at your regular rate.
With the newer Roth 401(k), which is offered in some but not all plans, you contribute after-tax income. Earnings accumulate tax deferred, but your withdrawals are completely tax free if your account has been open at least five years and you're at least 59 1/2.
In either type of 401(k), you can defer up to the federal cap, plus an annual catch-up contribution if you're 50 or older.
However, you may be able to contribute less than the cap if you're a highly compensated employee or if your employer limits contributions to a percentage of your salary. Your employer may match some or all of your contributions, based on the terms of the plan you participate in, but matching isn't required.
With a 401(k), you are responsible for making your own investment decisions by choosing from among investment alternatives offered by the plan. Those alternatives typically include separate accounts, mutual funds, annuities, fixed-income investments, and sometimes company stock.
You may owe an additional 10% federal tax penalty if you withdraw from a 401(k) before you reach 59 1/2. You must begin to take minimum required distributions by April 1 of the year following the year you turn 70 1/2 unless you're still working. But if you prefer, you can roll over your traditional 401(k) assets into a traditional IRA and your Roth 401(k) assets into a Roth IRA.