If your employer is establishing a 401(k) plan, and you are considering participating in the plan, you should know about certain features of these plans.

A 401(k) plan is also known as a cash or deferred arrangement (CODA). Under a 401(k) plan, you have the option of either receiving an amount of cash or having the cash set aside in a qualified retirement plan. By electing to have the cash set aside in a 401(k) plan, you will reduce your gross income and defer tax on this amount until the cash is distributed to you.

This cash or deferred election would include a salary reduction agreement between you and your employer. A contribution under this agreement is known as an elective contribution and is treated as a contribution by your employer which is taxable to you only when it is distributed, usually when you retire or terminate employment.

The amount of elective contributions, also called elective deferrals, which you can exclude from income for 2009 is $16,500 (2008 was $15,500). Elective contributions are also subject to any employer-provided limit, and, for highly compensated employees, the limit calculated under the actual deferral percentage (ADP) test.

When you reach age 50, if your employer's plan allows, you may make an additional “catch-up” contribution for 2009 of $5,500 ($5,000 for 2008) beyond these limits.

Total employer contributions, including elective deferrals (but not including catch-up contributions) may not exceed 100% of compensation or, for 2009, $49,000 ($46,000 for 2008), whichever is less.

Limitations on distributions is another important aspect of these plans.

Amounts in the plan attributable to elective deferrals are not available to you before one of the following events:

Retirement (or other separation from service);
Disability;
Attainment of age 59 1/2;
Hardship; or
Plan termination.

Eligibility rules for a hardship withdrawal are very stringent. Distribution must be necessary to satisfy an immediate and heavy financial need.

Depending on the terms of your employer's 401(k) plan, you may be able to make additional after-tax contributions. Although, these won't reduce your taxable pay, the investment earnings from the contributions are exempt from tax while in the 401(k) plan.

Your employer must test whether elective contributions made by highly compensated employees are discriminatory when compared with contributions made for non-highly compensated employees. If the amount of contributions made for the nonhighly compensated is “inadequate” according to the ADP test, some part of the contributions on behalf of the highly compensated may have to be paid out (returned) to them.

A 401(k) plan may contain a matching contribution feature, under which the employer will “match,” up to a specified limit, an employee's elective contribution. The amount of matching contributions, together with after-tax employee contributions for highly compensated employees, must meet a nondiscrimination test similar to the ADP test.

Matching contributions are “free money” from your employer. We encourage you to make the elective contributions necessary to obtain the maximum matching contributions from your employer.