What Is A 401(k) plan?

The 401(k) retirement plan was first introduced in 1978 and has become the most commonly used employer-sponsored plan on the market.

 

It gains its name from the section of tax code that it adheres to. Under this plan, employees typically contribute a portion of their paycheck, before federal and state taxes have been subtracted, into an investment portfolio. These investments can be as broad as a mutual fund or as specific as stocks and bonds. Once an employee reaches his or her retirement, the account balance is withdrawn in its entirety and can be subject to taxation.

A 401(k) plan offers more flexibility than other retirement options, as well as the opportunity to grow an employee’s contribution with well-placed investments. Depending on how the plan is set up, employees can choose where their money is invested and how much they wish to invest. Employers are not typically required to make contributions, but they can do so by either matching a percentage of an employee’s contribution or making a separate contribution of their own, such as in company stock.

Unlike defined benefit plans that offer guaranteed payments upon retirement, a 401(k) is only as good as its investments. This is important to keep in mind when choosing a 401(k) as your retirement option. Make sure you know the details of the plan your company offers and understand the level of responsibility you will hold over the investments.

Contributions

A 401(k) grows by employee and employer contributions. The nature of these contributions is what makes this plan stand out. A few of the unique features of a 401(k) plan are listed below:

  • Tax-Free Contributions – Employees who make tax-free contributions from their paychecks enjoy a lower gross income and therefore face fewer taxes in their working years. Once they retire, these contributions are taxed at the applicable rate.
  • Taxed Contributions – A Roth 401(k) allows employees to contribute a portion of his or her paycheck after tax has been taken out. This money is typically tax-free when withdrawn at retirement.
  • Matching Contributions – One of the more popular aspects of a 401(k) plan is the option for employers to match a percentage of their employees’ contributions. This can considerably increase the account balance of a 401(k). There are specific rules on when these matched funds can be claimed by the participant depending on how each 401(k) is operated.
  • Contribution Limits – There are annual limitations on how much an employee and employer can contribute to their 401(k) plans. These contribution limits are updated every year to reflect changing cost-of-living rates. Employees with higher salaries may be subject to stricter rules due to nondiscrimination laws set in place by the IRS.

Vesting is a term used when talking about the ownership of funds. Some companies may require an employee to wait a certain number of years before they are fully or partially vested in his or her employer’s contributions. Employees are always fully vested in their own contributions.

Due to the fact that 401(k) involves tax-based benefits, such as deferring a portion of an employee’s wages until retirement, the IRS implements annual Nondiscrimination Tests. The Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests ensure higher earning employees are not unfairly benefiting from the plan.

Important Features of a 401(K) Plan

Each plan adheres to a slightly different set of rules. There are several features to keep in mind when choosing a 401(k) plan over other available plans on the market. For example, some restrictions are placed on when the funds in a 401(k) can be withdrawn. Circumstances such as retirement, death or disability are a few examples of when an employee may withdraw their money. Early distribution of funds may result in a 10 percent penalty and further taxes.

 

It is possible for an employee to access their money before retirement by taking out a loan against the balance of his or her 401(k). However, loans are only made available if an employer permits it. A loan cannot be less than 50 percent of the account balance, and there are restrictions on when a loan can be paid back.

There may be some investment fees associated with a 401(k) plan. These fees will vary depending on how a company sets up the plan, and whether an employee decides to employ additional advisors to help manage the fund. Sometimes a company will enroll its employees into a 401(k) and automatically contribute a portion of their wages to the plan. However, there are ways an employee can opt-out of automatic enrollment if they do not wish to participate.

Types of 401 (k) Plans

There are three types of 401(k) plans available to employers. Each type offers slightly different variations on the same benefits and procedures. Outlined below are the three 401(k) plans with a brief explanation of their differences.

 

  • Traditional and Roth 401(k) plans – These are the most common type of 401(k) plans. They allow employees to make pre-tax contributions from their paychecks into the plan. Employers can make their own contributions or match their employees’ contributions. Vesting restrictions may apply to this type of plan, effecting how long an employee must work for a company before he or she has the right to all or part of the employer’s contributions. A Roth 401(k) plan is very similar to a traditional plan, but instead, allows its participants to make taxed contributions.
  • Safe harbor 401(k) plans – There are subtle differences between a traditional and safe harbor plan. Under the rules of a safe harbor plan, contributions made by an employer must be fully vested. This means the employee does not have to work for a certain length of time to gain the right to these funds.
  • SIMPLE 401(k) plans – This type of plan is for small businesses of 100 employees or less. The SIMPLE plan has similar attributes to the safe harbor plan, but with a few key difference. A SIMPLE plan does not allow participants to enroll in other retirement plans from their employer. Any contributions that an employer makes under a SIMPLE plan must be fully vested, and the participation in nondiscrimination tests is not required.

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