The 401K plan is an employer sponsored retirement savings plan in which the employee transfers a portion of his/her wage into the retirement account. This plan allows an employee to save for the retirement without attracting any immediate income tax on the deferred amount. The 401K tax deductions are granted until the money is withdrawn. Usually, the job of monitoring the plan is sourced to a third party controller such as an insurance company, a bank, or a mutual fund. 401K tax deductions can be diverted to investments such as stocks, mutual funds, or bonds. Some companies even allow these deductions to be utilized for purchasing the company stock. The employee may be given a free hand for reallocating the 401K tax deductions into the investment of his/her choice at any time.

Usually offered by companies in the private sector, this plan can also be adopted by self-employed persons and former government entities. In the trustee directed 401K plan, a trustee is appointed to foresee the investment options into which the 401K tax deductions can be diverted. In the participant directed 401K plan, the choice of investment is left to the employee. Some employers may contribute into the plan as an incentive for employees.

Most plan structures sanction deductions up to15% of the employees wages. The maximum pre-tax contribution amount is fixed by the government and adjusted according to the annual inflation rate. In case the employee is 50 years or above, he/she can make extra catch-up contribution amounting to $4,000 each year. Some companies may not permit the extra catch-up contributions.

401K tax deductions help save a considerable amount in federal income taxes. The amount deferred is later taxed during the withdrawal at a rate dependent on the employees post-retirement financial status. The profit earned on the investments is exempted from taxes.

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