What is a key characteristic of a 401(k) plan?

A key characteristic of a 401(k) plan is that it allows employees to save for retirement with pre-tax contributions. This feature is significant because contributions made to a 401(k) are deducted from an individual’s taxable income, effectively reducing the amount of income tax that the employee must pay for the year in which the contributions are made. This tax-deferred growth allows funds in a 401(k) to compound over time without being impacted by taxes until withdrawal, which typically happens during retirement when the individual's tax rate may be lower.

This characteristic distinguishes 401(k) plans from other savings vehicles that may require contributions to be made with after-tax dollars, where taxes are paid upfront. Additionally, while there are restrictions on withdrawals from 401(k) plans to discourage early access, it is not entirely true that employees are prohibited from withdrawing funds for any reason—there are specific circumstances that allow for withdrawals or loans, although they may incur penalties or tax implications. Lastly, 401(k) plans do not provide guaranteed returns; the growth of funds is subject to market performance, meaning the returns can vary based on investment choices and market conditions.