A section 401(k) plan is a type of deferred compensation plan in which an employee can elect to have his or her employer contribute a portion of his or her wages to the plan on a pre-tax basis. These deferred wages are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 (PDF) since they were not included in the taxable wages on your Form W-2 (PDF). However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.

The amount that an employee may elect to defer to a 401(k) plan is limited. During 2001, an employee cannot elect to defer more than $10,500 for all 401(k) plans in which the employee participates. But if the employee participates in a SIMPLE 401(k) plan, the limit for 2001 is $6,500. Both of these limits are indexed for inflation. Generally, all deferred compensation plans in which the employee participates must be considered to determine if the $10,500 limit is exceeded. All contributions to retirement plans (including deferred compensation plans) are subject to additional limits. Refer to Publication 525 (PDF), Taxable and Nontaxable Income, for more information about elective deferrals. Employers should refer to Publication 560 (PDF), Retirement Plans for Small Business, for information about setting up and maintaining retirement plans for employees, including 401(k) plans.

Distributions from a 401(k) plan may qualify for optional lump-sum distribution treatment or rollover treatment as long as they meet the respective requirements. For more information, refer to Tax Topic 412, Lump-Sum Distributions, Tax Topic 413, Rollovers from Retirement Plans, and Tax Topic 555, 10-Year Tax Option for Lump-Sum Distributions.

Many plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Hardship distributions from a 401(k) plan are limited to the amount of the employee's elective deferrals only, and do not include any income earned on the deferred amounts. They are not treated as eligible rollover distributions.

Distributions received before age 59 1/2 may be subject to an early distribution penalty of 10% additional tax. For more information about the treatment of retirement plan distributions, refer to Publication 575 (PDF), Pension and Annuity Income.

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