Under section 401(K) of the Internal Revenue Code, a deferred compensation plan set up by an employer so that employees can set aside money for retirement on a pre-tax basis. Employers may match a percentage of the amount that employees contribute to the plan. Contributions by both employees and employers, as well as investment earnings and interest, are not taxed until the employee withdraws the money; if the employee withdraws the money before retirement age, he or she pays an early withdrawal penalty tax. Currently, employees are allowed to annually contribute up to 15 percent of their salary but no more than $11,000 ($12,000 for people 50 or older). Many employers now offer these deferred compensation plans in lieu of or in addition to pensions.
Copyright © 2011 Campbell R. Harvey, Professor of Finance, Fuqua School of Business at Duke University