A section 401(k) plan is an employee retirement plan into which an employee can elect to contribute a portion of his or her wages before taxes each year. These deferred wages are not subject to income tax withholding at the time of deferral, nor are they deductible on your Form 1040 since they were not included in taxable wages on your Form W-2. However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.

The amount that an employee may elect to defer is limited. During 1996 an employee cannot elect to defer more than $9,500 per year for all cash or deferred arrangements in which the employee participates. This yearly limitation is indexed for inflation and generally cannot exceed the lesser of 25 percent of compensation or $30,000 when added to other employer contributions for the participant. Generally, all plans maintained by an employer must be considered to determine if contribution limits are exceeded. The employer may specify a lower maximum deferral percentage in the plan.

Distributions before age 59½ may be subject to an early distribution penalty of 10%. For more information on this, refer to Publication 575, Pension and Annuity Income (Including Simplified General Rule), or Publication 560, Retirement Plans for the Self-Employed.

Many plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Hardship distributions are limited to the amount of the employee's elective deferral only, and do not include any income deferrals earned on the deferred amounts. Distributions from a 401(k) plan qualify for optional lump- sum treatment and rollover treatment as long as they meet the respective requirements. For more information, refer to [Topic 412], Lump-Sum Distributions, [Topic 413], Rollovers from Retirement Plans and [Topic 555], 5- or 10- Year Tax Options for Lump-Sum Distributions.

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