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 Once an employee reaches his or her retirement, the account balance is withdrawn in its entirety and can be subject to taxation.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.
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:
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.
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 For example, some restrictions are placed on when the funds in a 401(k) can be withdrawn.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.
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.
