USA 401k Retirement System
In the United States of America, a 401(k) plan allows a worker to save for retirement and have the savings invested while deferring income taxes an income tax is a tax levied on the financial income of persons, corporations, or other legal entities. Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate tax, corporate income on the saved money and earnings until withdrawal. The employee Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as: "A person in the service of another under any contract of hire, express or implied, oral or written, where the employer has the power or right to control and direct the employee in the material details of how elects to have a portion of his or her wages A wage is a compensation, usually financial, received by a worker in exchange for their labor paid directly, or "deferred," into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds A mutual fund is a professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities. The mutual fund will have a fund manager that trades the pooled money on a regular basis. Currently, the worldwide value of all mutual that emphasize stocks In business and finance, a share of stock means a share of ownership in a corporation (company). In the plural, stocks is often used as a synonym for shares especially in the United States, but it is less commonly used that way outside of North America, bonds In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest and/or to repay the principal at a later date, termed maturity, money market In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquidity funding for the global financial system. The money market is where short-term obligations such as Treasury bills, commercial paper and bankers' acceptances are bought and sold investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.
Some assets in 401(k) plans are tax deferred
Tax deferral refers to instances where a taxpayer can delay paying taxes to some future period. In theory, the net taxes paid should be the same. In practice, due to the time value of money, paying taxes in future is usually preferable to paying them now. Taxes can sometimes be deferred indefinitely, or may be taxed at a lower rate in the future, before the January 1, 2006, effective date of the designated Roth the Roth 401 is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees account provisions, all 401(k) contributions were on a pre-tax basis (i.e., no income tax is withheld Withholding, in general, usually refers to a deduction of money from an employee's wages or salary by an employer, for projected or actual Income tax liabilities, see: on the income in the year it is contributed), and the contributions and growth on them are not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k). Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed). In addition to Roth and pre-tax contributions, some participants may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax basis and may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account is taxed as ordinary income Under the United States Internal Revenue Code, the type of income is defined by its character. Ordinary income is usually characterized as income other than capital gain. Ordinary income can consist of income from wages, salaries, tips, commissions, bonuses, and other types of compensation from employment, interest, dividends, or net income from a.
- Tax consequences
- Withdrawal of funds
3.1 Required minimum distributions
- Technical details
5.1 Contribution Limits
5.2 Highly Compensated Employees (HCE)
- 401(k) plans for certain small businesses or sole proprietorships
- Other countries
- See also
- External links
As an employee benefit, a 401(k) must be sponsored by an employer; typically a private sector corporation a corporation is a legal entity separate from the persons that form it. In British tradition it is the term designating a body corporate, where it can be either a corporation sole or a corporation aggregate (involving more persons). In American and, increasingly, international usage, the term denotes a body corporate formed to conduct business, A self-employed individual can set up a 401(k) plan, and, until 1986, a government entity could do so as well. The employer is responsible for creating and designing the plan. And while ERISA (Employee Retirement Income Security Act The Employee Retirement Income Security Act of 1974 (Pub.L. 93-406, 88 Stat. 829, enacted September 2, 1974) is an American federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. ERISA was of 1974) defaults reporting and disclosure to the plan sponsor; there is no default for a fiduciary the fiduciary duty is a legal relationship of confidence or trust between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary. One party, for example a corporate trust company or the trust department of a bank, holds a fiduciary relation or acts in a fiduciary capacity to another, such as one whose funds are, and the plan sponsor must either identify at least one "named fiduciary" in the plan document or it must write a procedure into the plan for appointing the named fiduciary. While ERISA defaults total discretion and control over plan assets and investments to the plan's trustee, many plan sponsors override this default structure by giving responsibility for selecting and monitoring plan investments to the named fiduciary, often a committee of internal employees, or a mix of internal employees and outside persons bringing in particular fiduciary expertise.
A 401(k) plan is a type of defined contribution plan the terms retirement plan or superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and (under the IRS's definition). It is a salary reduction plan, where employees must choose a percentage of their salary to contribute to the plan, and the plan spells out the extent of employer matching, if any (regardless of profits). Employee taxable salaries are reduced by these contributions, the contributions are invested, and any earnings are tax-deferred, i.e., until the employee draws the money out at retirement. Two other types of defined contribution plans are profit-sharing plans, in which the plan specifies, for example, that the employer will contribute 10% of net profits each year (divided among participant accounts), and money purchase pension plans, in which the plan defines the contribution as 10% of participants' annual salary, for example. 401(k) plans are not a defined benefit plan a pension is a steady income given to a person upon retirement, typically in the form of a guaranteed annuity. A pension created by an employer for the benefit of an employee is commonly referred to as an occupational or employer pension. Labor unions, the government, or other organizations may also fund pensions, because the benefit formula (specifying what participants will receive at retirement) is not spelled out in the plan. 401(a) profit sharing plans and money purchase pension plans, and 401(k) plans, are individual account plans, because each participant's benefit is the value of an individual account to which the contributions have been made plus any investment income and less any losses. If investments do well, there will be more in the account at retirement; if investments do poorly, there will be less.
In addition, 401(k) plans are tax-qualified plans covered by ERISA such that assets held by the plans are generally protected from creditors A creditor is a party that has a claim to the services of a second party. The first party, in general, has provided some property or service to the second party under the assumption (usually enforced by contract) that the second party will return an equivalent property or service. The second party is frequently called a debtor or borrower. The of the account holder, which in the past was generally not true for IRA plans. In the case of employer bankruptcy is a legally declared inability or impairment of ability of an individual or organization to pay its creditors. Creditors may file a bankruptcy petition against a debtor in an effort to recoup a portion of what they are owed or initiate a restructuring. In the majority of cases, however, bankruptcy is initiated by the debtor (a ", all 401(a) (pension and defined contribution plans) and 401(k) plans are protected, because of the rule that contributions must accrue to the exclusive benefit of employees in general. Even though pension plans are backed by insurance through the Pension Benefit Guaranty Corporation The Pension Benefit Guaranty Corporation is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 (ERISA) to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and uninterrupted payment of pension benefits, and keep, workers whose company enters bankruptcy may not receive the full value of their pension. ERISA protection of 401(k) assets does not extend to losses in the value of investments that participants choose. Employees investing their 401(k) in their own employer stock face the possibility of losing the value of their retirement accounts that is invested in employer stock along with their jobs if their employer goes out of business.
Defined benefit plans have a definitely determinable benefit amount that usually has a fixed formula, regardless of how the underlying plan assets perform. Defined contribution plans the terms retirement plan or superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and according to Section 414(i) of the IRC The Internal Revenue Code is the main body of domestic statutory tax law of the United States organized topically, including laws covering the income tax (see Income tax in the United States), payroll taxes, gift taxes, estate taxes and statutory excise taxes. The Internal Revenue Code is published as Title 26 of the United States Code (USC), and has individual accounts. Because plan sponsors want to take advantage of the exemption from the fiduciary duty The fiduciary duty is a legal relationship of confidence or trust between two or more parties, most commonly a fiduciary or trustee and a principal or beneficiary. One party, for example a corporate trust company or the trust department of a bank, holds a fiduciary relation or acts in a fiduciary capacity to another, such as one whose funds are to diversify Diversification in finance is a risk management technique, related to hedging, that mixes a wide variety of investments within a portfolio. Because the fluctuations of a single security have less impact on a diverse portfolio, diversification minimizes the risk from any one investment plan assets to minimize the risk of large losses by using ERISA The Employee Retirement Income Security Act of 1974 (Pub.L. 93-406, 88 Stat. 829, enacted September 2, 1974) is an American federal statute that establishes minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. ERISA was Section 404(c); these plans usually provide each worker the ability to control the contents of his account. The account value may fluctuate in value based on the underlying investments. There is a risk that returns may even be negative.
Some companies match employee contributions to some extent, paying extra money into the employee's 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing Profit sharing, when used as a special term, refers to various incentive plans introduced by businesses that provide direct or indirect payments to employees that depend on company's profitability in addition to employees' regular salary and bonuses. In publicly traded companies these plans typically amount to allocation of shares to employees contributions into the 401(k) plan or just contribute a fixed percentage of wages. These contributions may vest in law, vesting is to give an immediately secured right of present or future enjoyment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset. When the right, interest or title to the present or future possession of a legal estate can be transferred to any other party, it is over several years as an inducement to the employee to stay with the employer.
When an employee leaves a job, the 401(k) account generally stays active for the rest of his or her life, though the accounts must begin to be drawn out beginning the April 1 of the calendar year after the attainment of age 70½ (except that under SBJPA 1996, those still employed can defer). In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, when the employee leaves the company, the account can be rolled over into an IRA An Individual Retirement Arrangement is a retirement plan account that provides some tax advantages for retirement savings in the United States at an independent financial institution, or if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can "roll over" the account into a new 401(k) account hosted by the new employer.
Comparable types of salary-deferral retirement plans include 403(b) A 403 plan is a tax-advantaged retirement savings plan available for public education organizations, some non-profit employers (only US Tax Code 501(c)(3) organizations), and self-employed ministers in the United States. It has tax treatment similar to a 401(k) plan, especially after the Economic Growth and Tax Relief Reconciliation Act of 2001 plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and 457 plans The 457 plan is a type of tax advantaged defined contribution retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis. For the most part the plan operates similarly to a 401 or 403(b) plan most which cover employees of state and local governments and certain tax-exempt entities.
Significant new rules are allowing benefits companies (Plan Providers) and those involved in selling benefits to plans (Plan Advisors) to expand their capabilities to sell services to Plan Sponsors (those responsible for managing employer-sponsored retirement plans The terms retirement plan or superannuation refer to a pension granted upon retirement . Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and for companies).
401k Tax consequences
Most 401(k) contributions are on a pre-tax basis. Starting in the 2006 tax year, employees can either contribute on a pre-tax basis or opt to utilize the Roth 401(k) The Roth 401 is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A , and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees provisions to contribute on an after tax basis and have similar tax effects of a Roth IRA A Roth IRA is an Individual Retirement Account allowed under the tax law of the United States. Named for its chief legislative sponsor, Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs. However, in order to do so, the plan sponsor must amend the plan to make those options available. With either pre-tax or after tax contributions, earnings from investments in a 401(k) account (in the form of interest, dividends, or capital gains) are not taxable events. The resulting compound interest Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding. A loan, for example, may have its interest compounded every month: in this case, a loan with $100 principal and 1% interest per without taxation can be a major benefit of the 401(k) plan over long periods of time.
For pre-tax contributions, the employee does not pay federal income tax a tax is a financial charge or other levy imposed on an individual or a legal entity by a state or a functional equivalent of a state. Taxes are also imposed by many sub national entities. Taxes consist of direct tax or indirect tax, and may be paid in money or as its labor equivalent (often but not always unpaid). A tax may be defined as a "on the amount of current income that he or she defers to a 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year's tax return. Currently this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket Tax brackets are the divisions at which tax rates change in a progressive tax system. Essentially, they are the cutoff values for taxable income - income past a certain point will be taxed at a higher rate and there were no other adjustments (e.g. deductions). The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement. The character for purposes of calculating a taxpayer's tax liability, character is the type of income. In the U.S. the Supreme Court decided in Commissioner_v._Glenshaw_Glass_Co. that income is an accession to wealth, however capital gain is of different character from ordinary income. Ordinary income includes earned wage income and interest income from lending of any gains (including tax favored capital gains) are transformed into "ordinary income" at the time the money is withdrawn.
For after tax contributions to a designated Roth account (Roth 401(k)), qualified distributions can be made tax free. To qualify, distributions must be made more than 5 years after the first designated Roth contributions and not before the year in which the account owner turns age 59 and a half, unless an exception applies as detailed in IRS code section 72(t). In the case of designated Roth contributions, the contributions being made on an after tax basis means that the taxable income in the year of contribution is not decreased as it is with pre-tax contributions. Roth contributions are irrevocable and cannot be converted to pre-tax contributions at a later date. Administratively Roth contributions must be made to a separate account, and records must be kept that distinguish the amount of contribution that is to receive Roth treatment.
Withdrawal of 401k funds
Virtually all employers impose severe restrictions on withdrawals while a person remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before the age of 59½ is subject to an excise tax An excise or excise tax is a type of tax charged on goods produced within the country (as opposed to customs duties, charged on goods from outside the country) equal to ten percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).
In any event any amounts are subject to normal taxation as ordinary income. Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan would have to resign from their employer. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59½ years of age. Money that is withdrawn prior to the age of 59½ typically incurs a 10% penalty tax unless a further exception applies.  This penalty is on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee's total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order A Qualified domestic relations order or QDRO is a legal order subsequent to a divorce or legal separation that splits and changes ownership of a retirement plan to give the divorced spouse their share of the asset or pension plan. QDROs may grant ownership in the participant's pension plan to an alternate payee, who must be a spouse, former spouse, and for deductible medical expenses (exceeding the 7.5% floor). This does not apply to the similar 457 plan The 457 plan is a type of tax advantaged defined contribution retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis. For the most part the plan operates similarly to a 401 or 403(b) plan most.
Many plans also allow employees to take loans a loan is a type of debt. This article focuses exclusively on monetary loans, although, in practice, any material object might be lent. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower from their 401(k) to be repaid with after-tax funds at pre-defined interest rates An interest rate is the price a borrower pays for the use of money they do not own, and the return a lender receives for deferring the use of funds, by lending it to the borrower. Interest rates are normally expressed as a percentage rate over the period of one year. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income or subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.
These loans have been described as tax-disadvantaged, on the theory that the 401(k) contains before-tax dollars, but the loan is repaid with after-tax dollars. This is not correct. The loan is repaid with after-tax dollars, but the loan itself is not a taxable event, so the "income" from the loan is tax-free. This treatment is identical to that of any other loan, as long as the balance is repaid on schedule. (A residential mortgage a mortgage is the transfer of an interest in property to a lender as a security for a debt - usually a loan of money. While a mortgage in itself is not a debt, it is lender's security for a debt. It is a transfer of an interest in land (or the equivalent), from the owner to the mortgage lender, on the condition that this interest will be returned or home equity line of credit A home equity line of credit is a loan in which the lender agrees to lend a maximum amount within an agreed period (called a term), where the collateral is the borrower's equity in his/her house may have tax advantages over the 401(k) loan; but that is because the interest on home mortgages is deductible, and unrelated to the tax-deferred features of the 401(k).)
Required minimum 401k distributions
An account owner must begin making distributions from their accounts at least no later than the year after the year the account owner turns 70½ unless the account owner is still employed at the company sponsoring the 401(k) plan. The amount of distributions is based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. Required minimum distributions apply to both pre-tax and after-tax Roth contributions. Only a Roth IRA A Roth IRA is an Individual Retirement Account allowed under the tax law of the United States. Named for its chief legislative sponsor, Senator William Roth of Delaware, a Roth IRA differs in several significant ways from other IRAs is not subject to minimum distribution rules. Other than the exception for continuing to work after age 70½ differs from the rules for IRA minimum distributions. The same penalty applies to the failure to make the minimum distribution. The penalty is 50% of the amount that should have been distributed, one of the most severe penalties the IRS applies.
In 1978, Congress amended the Internal Revenue Code by adding section 401(k), whereby employees are not taxed on income they choose to receive as deferred compensation rather than direct compensation. The law went into effect on January 1, 1980, and by 1983 almost half of large firms were either offering a 401(k) plan or considering doing so. By 1984 there were 17,303 companies offering 401(k) plans. Also in 1984, Congress passed legislation requiring nondiscrimination testing, to make sure that the plans did not discriminate in favor of highly paid employees more than a certain allowable amount. In 1998, Congress passed legislation that allowed employers to have all employees contribute a certain amount into a 401(k) plan unless the employee expressly elects not to contribute. By 2003, there were 438,000 companies with 401(k) plans.
Originally intended for executives, the section 401(k) plan proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Account An Individual Retirement Arrangement is a retirement plan account that provides some tax advantages for retirement savings in the United States (IRA); it usually came with a company match, and in some ways provided greater flexibility than the IRA, often providing loans and, if applicable, offered the employer's stock as an investment choice. Several major corporations amended existing defined contribution plans immediately following the publication of IRS proposed regulations in 1981.
A primary reason for the explosion of 401(k) plans is that such plans are cheaper for employers to maintain than a defined benefit the terms retirement plan or superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and pension the terms retirement plan or superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and for every retired worker. With a 401(k) plan, instead of required pension contributions the terms retirement plan or superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and, the employer only has to pay plan administration and support costs if they elect not to match employee contributions or make profit sharing contributions. In addition, some or all of the plan administration costs can be passed on to plan participants. In years with strong profits employers can make matching or profit-sharing contributions, and reduce or eliminate them in poor years. Thus 401(k) plans create a predictable cost for employers, while the cost of defined benefit plans the terms retirement plan or superannuation refer to a pension granted upon retirement. Retirement plans may be set up by employers, insurance companies, the government or other institutions such as employer associations or trade unions. Called retirement plans in the USA, they are more commonly known as pension schemes in the UK and Ireland and can vary unpredictably from year to year.
The danger of the 401(k) plan is if the contributions are not diversified, particularly if the company had strongly encouraged its workers to invest their plans in their employer itself. This practice violates primary investment guidelines about diversification. In the case of Enron the Enron scandal was a financial scandal involving Enron Corporation and its accounting firm Arthur Andersen that was revealed in late 2001. After a series of revelations involving irregular accounting procedures conducted throughout the 1990s, Enron was on the verge of bankruptcy by November of 2001. A white knight rescue attempt by a similar,, where the accounting scandal and bankruptcy caused the share price to collapse, there was no PBGC insurance The Pension Benefit Guaranty Corporation is an independent agency of the United States government that was created by the Employee Retirement Income Security Act of 1974 (ERISA) to encourage the continuation and maintenance of voluntary private defined benefit pension plans, provide timely and uninterrupted payment of pension benefits, and keep and employees lost the money they invested in Enron stock. Congress inserted trust law fiduciary liability upon employers who did not prudently diversify plan assets to avoid the chance of large losses inside Section 404 of ERISA, but it is unclear whether such fiduciary liability applies to trustees of plans in which participants direct the investment of their own accounts.
401k Contribution Limits
There is a maximum limit on the total yearly employee pre-tax salary deferral. The limit, known as the "401(k) limit", is $15,500 for the year 2008 and $16,500 for 2009.  For future years, the limit may be indexed for inflation, increasing in increments of $500. Employees who are 50 years old or over at any time during the year are now allowed additional pre-tax "catch up" contributions of up to $5,000 for 2008 and $5,500 for 2009. The limit for future "catch up" contributions may also be adjusted for inflation in increments of $500. In eligible plans, employees can elect to have their contribution allocated as either a pre-tax contribution or as an after tax Roth 401(k) contribution, or a combination of the two. The total of all 401(k) contributions must not exceed the maximum contribution amount.
If the employee contributes more than the maximum pre-tax limit to 401(k) accounts in a given year, the excess must be withdrawn by April 15 of the following year. This violation most commonly occurs when a person switches employer's mid-year and the latest employer does not know to enforce the contribution limits on behalf of their employee. If this violation is noticed too late, the employee may have to pay taxes and penalties on the excess. The excess contribution, as well as the earnings on the excess, is considered "non-qualified" and cannot remain in a qualified retirement plan such as a 401(k).
Plans which are set up under section 401(k) can also have employer contributions that (when added to the employee contributions) cannot exceed other regulatory limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, which is the lesser of 100% of the employee's compensation or $44,000 for 2006, $45,000 for 2007, $46,000 for 2008, and $49,000 for 2009. Employer matching contributions can be made on behalf of designated Roth contributions, but the employer match must be made on a pre-tax basis. 
Governmental employers in the US (that is, federal, state, county, and city governments) are currently barred from offering 401(k) plans unless they were established before May 1986. Governmental organizations instead can set up a section 457(g) The 457 plan is a type of tax advantaged defined contribution retirement plan that is available for governmental and certain non-governmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pre-tax basis. For the most part the plan operates similarly to a 401 or 403(b) plan most.
Highly Compensated Employees (HCE) in 401k
To help ensure that companies extend their 401(k) plans to low-paid employees, an IRS rule limits the maximum deferral by the company's "highly compensated" employees, based on the average deferral by the company's non-highly compensated employees. If the rank and file saves more for retirement, then the executives are allowed to save more for retirement. This provision is enforced via "non-discrimination testing". Non-discrimination testing takes the deferral rates of "highly compensated employees" (HCEs) and compares them to non-highly compensated employees (NHCEs). An HCE in 2008 is defined as an employee with compensation of greater than $100,000 in 2007 or an employee that owned more than 5% of the business at any time during the year or the preceding year. As an alternative to the $100,000 limit for determining HCEs, employers can elect to define the top-paid group of employees as the top 20% of employees ranked by compensation. That is for plans whose first day of the plan year is in calendar year 2007, we look to each employee's prior year gross compensation (also known as 'Medicare wages') and those who earned more than $100,000 are HCEs. Most testing done now in 2008 will be for the 2007 plan year when we compare employees' 2006 plan year gross compensation to the $95,000 threshold for 2006 to determine who is HCE and who is a NHCE.
The average deferral percentage (ADP) of all HCEs, as a group, can be no more than 2% greater (or 150% of, whichever is less) than the NHCEs, as a group. This is known as the ADP test. When a plan fails the ADP test, it essentially has two options to come into compliance. It can have a return of excess done to the HCEs to bring their ADP to a lower, passing, level. Or it can process a "qualified non-elective contribution" (QNEC) to some or all of the NHCEs to raise their ADP to a passing level. The return of excess requires the plan to send a taxable distribution to the HCEs (or reclassify regular contributions as catch-up contributions subject to the annual catch-up limit for those HCEs over 50) by March 15 of the year following the failed test. A QNEC must be an immediately vested contribution.
The annual contribution percentage (ACP) test is similarly performed but also includes employer matching and employee after-tax contributions. ACPs do not use the simple 2% threshold, and include other provisions which can allow the plan to "shift" excess passing rates from the ADP over to the ACP. A failed ACP test is likewise addressed through return of excess, or a QNEC or qualified match (QMAC).
There are a number of "safe harbor" provisions that can allow a company to be exempted from the ADP test. This includes making a "safe harbor" employer contribution to employees' accounts. Safe harbor contributions can take the form of a match (generally totaling 4% of pay) or a non-elective profit sharing (totaling 3% of pay). Safe harbor 401(k) contributions must be 100% vested at all times with immediate eligibility for employees. There are other administrative requirements within the safe harbor, such as requiring the employer to notify all eligible employees of the opportunity to participate in the plan, and restricting the employer from suspending participants for any reason other than due to a hardship withdrawal.
401(k) plans for certain small businesses or sole proprietorships
Many self-employed persons felt (and financial advisors agreed) that 401(k) plans did not meet their needs due to the high costs, difficult administration, and low contribution limits. But the Economic Growth and Tax Relief Reconciliation Act of 2001 The Economic Growth and Tax Relief Reconciliation Act of 2001, was a sweeping piece of tax legislation in the United States. It is commonly known by its abbreviation EGTRRA, often pronounced "egg-tar" or "egg-terra" and sometimes also known simply as the 2001 act (especially where the context of a discussion is clearly about (EGTRRA) made 401(k) plans more beneficial to the self-employed. The two key changes enacted related to the allowable "Employer" deductible contribution, and the "Individual" IRC-415 contribution limit.
Prior to EGTRRA, the maximum tax-deductible contribution to a 401(k) plan was 15% of eligible pay (reduced by the amount of salary deferrals). Without EGTRRA, an incorporated business person taking $100,000 in salary would have been limited in Y2004 to a maximum contribution of $15,000. EGTRRA raised the deductible limit to 25% of eligible pay without reduction for salary deferrals. Therefore, that same businessperson in Y2008 can make an "elective deferral" of $15,000 plus a profit sharing contribution of $25,000 (i.e. 25%), and - if this person is over age 50 - make a catch-up contribution of $5,000 for a total of $45,000. For those eligible to make "catch up" contribution, and with salary of $136,000 or higher, the maximum possible total contribution in 2008 would be $51,000. To take advantage of these higher contributions, many vendors now offer Solo-401(k) plans or Individual (k) plans, which can be administered as a Self-Directed 401(k), allowing for investment into real estate, mortgage notes, tax liens, private companies, and virtually any other investment.
Note: an unincorporated business person is subject to slightly different calculation. The government mandates calculation of profit sharing contribution as 25% of net self employment (Schedule C) income. Thus on $100,000 of self employment income, the contribution would be 20% of the gross self employment income, 25% of the net after the contribution of $20,000.