Understanding Traditional 401(k) Plans

401(k) plans have become one of the most popular ways for employees to save money for retirement. These plans are offered by employers and allow workers to set aside part of their salaries to save for retirement.

Offering A Plan

Businesses including sole proprietorships, partnerships, limited-liability corporations, and incorporated businesses may offer 401(k) plans to all eligible employees. At a minimum, this includes everyone over the age of 21 who has been with the company at least one year and worked for at least 1,000 hours in that year. Companies are allowed to exclude unionized workers and any non-resident aliens who have no U.S. source of income. They may also make their plan less restrictive than the minimum required, based upon their own demographics and objectives.

Contribution Limits

Once a 401(k) plan is set up, the employer generally can make income-tax-deductible contributions up to 25 percent of the total compensation of all eligible employees. Employees can elect to make contributions from their paycheck before paying federal income taxes or after-tax as a Designated Roth Contribution. And any investment earnings within the plan grow tax-deferred until the funds are withdrawn in retirement. The maximum salary deferral that employees can contribute in 2012 is $17,500, with an additional $5,500 if they are age 50 or older.

If employees make Designated Roth Contributions, they generally pay tax on those contributions when they are made, but don't owe tax on the money when it is withdrawn.

Other Considerations

Employers do not have to contribute to the 401(k) plans that they offer, but most do. Some choose to contribute for all employees a flat amount of money, some contribute a percentage of the employee's compensation, and others match the employee's contribution. The employer's contributions may vest over time, meaning that the employee may have to stay with the company for several years in order to receive the full amount. The employee's contribution is fully vested when it is made by the employer to the plan.

Some employers allow employees to take out loans against the funds in their 401(k) plans. Withdrawals are usually not allowed until the employee leaves the company. When that happens, the employee can roll the funds into an IRA without paying taxes. If the employee decides to keep the money, then income taxes on the contributions and earnings will generally have to be paid along with a 10 percent penalty tax if the employee is under 59½.

Neither State Farm nor its agents provide tax or legal advice. Please consult your own adviser regarding your particular circumstances.