In an effort to help encourage Americans to save more for retirement, Congress enacted the Tax Reform Act in 1978. The Act allows people to save for retirement while lowering their state and federal taxes. The term 401(k) refers to the section number and paragraph in the Internal Revenue Code — section 401, paragraph (k).
401(k) is the most widely used investment vehicle through which an individual can save for retirement. It is a plan set up by an employer, where employees can contribute and invest the money tax free until withdrawal. In some cases, the employer might match the contribution of the employee.
The Internal Revenue Service dictates on how much an employee can contribute, and when the individual can withdraw funds from the plan. If the employee withdraws funds from 401(K) before the retirement age, they might be faced with penalties.