401(k) plans must be sponsored by an employer, typically a private sector corporation, but self employed individuals can set them up also, and previously government entities could too. The employer acts as a plan fiduciary and is responsible for creating and designing the plan as well as selecting and monitoring plan investments. (In practice, nearly all employers outsource all of this work to one or more financial services companies, such as a bank, mutual fund, third party administrator, or insurance company.)
The employee elects to have a portion of his or her salary paid directly, or "deferred", into their 401(k) account. In trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time.
Some companies match employee contributions to some extent, paying extra money into the employee's 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing contributions into the 401(k) plan. These contributions may vest over several years as an inducement to the employee to stay with the employer.
When an employee leaves a job, the 401(k) account generally stays active for the rest of his or her life, though the accounts must begin to be drawn out beginning at age 70-1/2. In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can "roll over" the account into a new 401(k) account hosted by the new employer, or into an IRA.
Tax benefits and considerations
The employee does not pay federal income taxes on the amount of current income that he or she defers to a 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year is federally taxed as though they had earned only $47,000 in that year, ignoring other deductions. In 2004, this would represent a near term $750 savings in taxes for a single worker, assuming they remained in the 25% marginal tax bracket when taking into account other deductions and adjustments.
Furthermore, all earnings from the investments in a 401(k) account are not taxed until withdrawn. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over the years.
The employee finally pays taxes on the money as they withdraw it, generally after retirement. The taxes are at the "ordinary income" rate, falling into whatever tax bracket the employee is in at the time the money is withdrawn. The assumption is often made that the employee will be in a lower tax bracket in retirement, but this assumption is not always realistic or guaranteed to be correct.
The IRS allows the tax advantage for income deferred into a 401(k), but places the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59 1/2 years of age. Money that is withdrawn prior to 59 1/2 is typically assessed with a 10% penalty tax immediately unless a further exception applies.[1] This penalty is of course on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee being totally and permanently disabled, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor).
One option for withdrawal from a 401(k) while currently employed (and before reaching age 59-1/2) is a hardship distribution with specific hardship rules applying. Hardship withdrawals are subject to the 10% penalty if made before age 59 1/2.
Though the Law may permit it, some plans do not offer many of the above withdrawal options. For example, some plans do not allow withdrawals for hardship.
Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income nor subject to the 10% penalty as long as it is paid back either before separation from service or immediately upon separation.
History
In 1978, Congress amended the Internal Revenue Code to add section 401 (K); and work on developing the first plans began in 1979. [2] Originally intended for executives, 401(K) proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Account (IRA); it usually came with a company match, and provided greater flexibility in some ways than the (IRA), often providing loans and an employer stock option. The first Fortune 500 company to allow general employees the option of investing in a 401(k) plan was Chrysler, now a subsidiary of DaimlerChrysler, in 1981. Interestingly enough, this plan, created by Raymonde B. Wert II of Merrill Lynch, was also the first 401(k) plan to allow investing in any equity position, rather than a limited number of plan chosen investment positions.
In addition, 401(k) plans are tax-qualified plans covered by the Employee Retirement Income Security Act of 1974 (ERISA), so assets held by the plans are generally protected from creditors, which in the past was generally not true for IRA's.
Much of the reason for the explosion of 401(k) plans was because they are cheaper for employers than maintaining a pension for every retired worker. In most cases, defined contribution plans are less expensive than defined benefit plans for employers. 401(k) plans also create a predictable cost for employers while the cost of defined benefit plans can vary unpredictably from year-to-year.
Technical details
There is a maximum yearly employee salary deferral contribution. The limit in 2005 is $14,000 for employees under the age of 50. Employees over the age of 50 are now allowed an additional "catch up" provision of up to $4,000 in 2005. If the employee somehow contributes more than the maximum to a 401(k) account, the excess must be withdrawn; if this is noticed too late, the employee may have to pay taxes and penalties on the excess and move it to another type of account.
Plans set up under section 401(k) can also have employer contributions that (when added to the employee contributions) can exceed the above limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, or the lesser of the employees compensation or $42,000 for 2005.
Governmental employers in the US (that is, federal, state, county, and city governments) are currently barred from offering 401(k) plans unless they were established before May 1986. Governmental organizations instead can set up a section 457(g).
To help ensure that companies extend their 401(k) plans to low-paid employees, an IRS rule limits the maximum deferral by the company's "highly compensated" employees, based on the average deferral by the company's non highly compensated employees. If the rank and file saves more for retirement, then the executives are allowed to save more for retirement. This provision is known as discrimination testing.
There are a number of "safe harbor" provisions that can allow a company to avoid the 401(k) discrimination testing. This includes making a "safe harbor" employer contribution to employees accounts. Safe harbor contributions can take the form of a match (generally totalling 4% of Pay) or a non-elective profit sharing (totalling 3% of Pay). Safe Harbor 401(k) contributions must be 100% vested at all times.
401(k) plans for certain small businesses or sole proprietorships
Many self-employed persons felt (and financial advisors agreed) that 401(k) plans did not meet their needs due to the high costs, difficult administration, and low contribution limits. But the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made 401(k) plans more beneficial to the self-employed. The two key changes enacted related to the allowable "Employer" deductible contribution, and the "Individual" IRC-415 contribution limit.
Prior to EGTRRA, the maximum tax-deductible contribution to a 401(k) plan was 15% of eligible pay (reduced by the amount of Salary Deferrals). Without EGTRRA, an incorporated business person taking $100,000 in Compensation would have been limited in Y2004 to a maximum contribution of $15,000.
EGTRAA raised the deductible limit to 25% of eligible Pay without reduction for Salary Deferrals. Therefore, that same businessperson in Y2004 can defer $13,000, make a profit sharing contribution of $25,000 (i.e 25%), and - if this person is over age 50 - make a catch-up contribution of $3,000 for a total of $41,000 - the maximum allowed under the higher IRC-415 limit.
To take advantage of these higher contributions, many vendors now offer Solo-401(k) plans or Individual(k) plans.
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