401(k) plans are so called because these accounts are governed by IRS tax code 401(k). The IRS tax codes allow for income, under certain qualifying circumstances, to be tax-deferred until use. This means that the contributions made to a 401(k) fund are not taxed until retirement (or until the money is withdrawn; while this can be done before retirement age there are heavy penalties applicable). Employees who participate in a 401(k) designate a portion of their salary to be deposited in the fund before income taxes on it are assessed.

Sometimes employers may offer an additional contribution to the fund. These contributions may be calculated by percentage of participants’ salary or matching participant contributions, or through a profit sharing formula. Employers who contribute to participants’ retirement savings offer prospective employees a valuable incentive to join their company, and create a sense of loyalty in current employees.