Retirement - What is a 401K Plan?

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What is 401(k) plan?

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A 401(k) plan is a retirement plan in which an employee can elect to have the employer contribute part of the employee's wages to the plan on a pretax basis. These deferred wages are not subject to income tax withholding at the time of deferral. The deferred wages are not reflected on Form 1040 since they were not included in taxable wages of box 1, Form W-2. However, they are included as wages subject to social security, Medicare and federal unemployment taxes. The amount an employee can elect to defer is limited.  The popular 401(k) retirement plan draws its dull name from the Section 401 of the Internal Revenue Code, which also created such exciting programs as the 403(b) from Section 403 and the 457 plan from (you guessed it) Section 457.

A section 401(k) plan is a retirement plan in which an employee can elect to have his or her employer contribute a portion of his or her wages to the plan on a pre-tax basis. These deferred wages are not subject to income tax withholding at the time of deferral, and they are not deductible on your Form 1040 since they were not included in taxable wages on your Form W-2. However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.  The biggest difference between a 401(k) and a "regular pension" is that a 401(k) gives you much more control over your retirement nest egg. A 401(k) is funded with your own money and, in some cases, by a contribution from your employer as well. You decide how much to save and how to invest. A traditional, "regular" pension is funded and controlled by your employer.  There are two types of pension plans: defined contribution (where the employer contributes a percentage of compensation determined by the formula in the plan document) and defined benefit. A "defined benefit plan" promises to pay you a specific monthly income in retirement -- in other words, a defined benefit. What you get when you retire will be based on your salary and the number of years you worked for the company. The company must put aside enough money each year to fulfill this promise but occasionally -- as some workers have unfortunately discovered -- it’s a promise that the employer may not be able to keep. Sometimes employers go bankrupt.
Most pension plans are covered by the Pension Benefit Guarantee Corp., which guarantees benefits to workers even if a firm is liquidated in bankruptcy. There are some plans that are not covered, however, such as those offered by professional service firms (such as doctors and lawyers) with fewer than 26 employees, by church groups or by federal, state or local governments.

Technically, 401(k) plans are considered profit-sharing plans. But on a practical level, they’re usually different in several ways from the classic profit-sharing plan. In a profit-sharing plan, the employer makes contributions for eligible employees whether or not they also contribute to the plan. However, In a 401(k) plan eligible employees can choose to participate or not. If they choose to participate, they make their contributions pre-tax through a salary deferral agreement with the employer. Their deferral may or may not be matched by the employer. Since it is a type of profit sharing plan the employer can also make profit sharing contributions to the plan. These contributions (also called non-elective contributions) are allocated to all eligible employees whether they contribute to the plan through deferrals or not.

Participation Standards:  Some companies allow workers to join their 401(k) plans immediately. But other companies utilize a federal law that allows firm to wait until a worker has logged at least one year of service before joining the plan. The reason: Many employees quit before their first year is up, and companies want to avoid the administrative costs involved in setting up a 401(k) for a worker who might not stay very long. A company is also allowed to exclude anyone under the age of 21. In part, that’s because younger employees often don’t take advantage of the plans even when they are eligible (even though they should). If younger workers are eligible to join the plan but don’t, their lower participation rate can reduce the amount that other employees are permitted to contribute because of federal rules.  

Contribution Limits:  The amount that an employee may elect to defer is limited. During 2000 an employee cannot elect to defer more than $10,500 per year ($6,000 per year for SIMPLE plans) for all cash or deferred arrangements in which the employee participates. This yearly limitation is indexed for inflation. All contributions to retirement plans (including deferred compensation plans) are subject to additional limits. Refer to Publication 525, Taxable and Nontaxable Income, for more information about elective deferrals. Employers should refer to Publication 560, Retirement Plans for Small Business, for information about setting up and maintaining retirement plans for employees, including 401(k) plans. Generally, all plans maintained by an employer must be considered, to determine if contribution limits are exceeded.

Distributions:  Distributions from a 401(k) plan may qualify for optional lump-sum distributions or rollovers as long as they meet the respective requirements. For more information, refer to Topic 412, Lump-Sum Distributions, Topic 413, Rollovers from Retirement Plans, and Topic 555, 5- or 10- Year Tax Option for Lump-Sum Distributions.

Many plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Hardship distributions are limited to the amount of the employee's elective deferral only, and do not include any income earned on the deferred amounts. Beginning in 1999, they will no longer be treated as eligible rollover distributions.

Distributions received before age 59½ may be subject to an early distribution penalty of 10% additional tax. Early distributions from a Simple 401(k) plan will be subject to a 25% additional tax if the withdrawal is made within the first two years of participation in the Simple Plan. For more information refer to Publication 575,

Investment Choices:  The money you put into a 401(k) plan is invested according to the choices you’ve made from a list of options offered by your employer. These options typically include stock and bond investment(s), money market funds, a guaranteed investment contract (GIC) that pays a fixed interest rate and your company’s stock.

Information About The Plan:  The federal government requires companies to provide only minimal information to workers who take part in a 401(k) plan. Technically, all you’re entitled to is a summary of how the plan works, a summary annual report and an annual statement. If the plan allows you to invest in the company’s stock, you are also entitled to receive a prospectus or similar document. Fortunately, many companies provide far more, and you can also do your own research. For example, if the investment(s) is offered in your 401(k), you’re free to contact the fund directly and ask for its performance history and other pertinent information. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), federal disclosure requirements are so minimal "because 401(k) plans are governed by a law that was written before they existed-the 1974 Employee Retirement Income Security Act, better known as ERISA. ERISA didn’t anticipate pension plans in which employees would make most of the investment decisions; consequently, its disclosure rules are relatively undemanding. But don’t worry, you probably won’t have any difficulty getting much more information than ERISA requires. Employers are strongly motivated to provide employees with all the information they need to use the plan wisely."

What If I Want To Check The Investment Performance?  If you have invested in a 401(k) retirement plan, it’s important to stay abreast of how your investment is faring. At a minimum, the company that administers your plan will provide an annual statement that shows the amounts you have contributed and how those investments have performed. Many plans report on a semi-annual or quarterly basis, and some even issue monthly updates. Of course, you can probably get a pretty good handle on how your 401(k) retirement portfolio is doing on a daily or weekly basis by checking the business section of your local newspaper or by reading publications such as The Wall Street Journal or Barron’s. If the bulk of your portfolio is in investment(s) or your company’s stock, for instance, those publications can tell you how much their value has changed over the course of a given day or week.

Is the Account Guaranteed?  NO.  Employers never guarantee 401(k) accounts. They are instead considered "fiduciaries" of 401(k) plans, which means they are legally responsible for supervising-not guaranteeing-the money you invest. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), this supervisory relationship obligates the employer "to protect your financial interests by choosing reputable and competent plan trustees, administrators and investment managers and continuously monitoring their performance of their duties. If employers choose to follow the voluntary 404(c) regulations established by the Department of Labor, they must give plan participants at least three distinctly different investment choices, each of which has a different level of risk. You must also be given the opportunity to move your money among these investments at least quarterly, and sufficient information to make sensible, informed investment decisions. But your employer doesn’t offer you protection against any investment losses you may suffer."   Although most traditional pension plans are insured by the federal government, there is no such guarantee for 401(k) accounts. Traditional pension plans are insured by the federal Pension Benefit Guaranty Corp. because the government wants to ensure that the payments a company promises its retirees will indeed be made. But 401(k)s do not involve a promise of future benefits. The value of your account will rise and fall over the course of the years, and you could theoretically be wiped out if your investments perform badly. If it helps you sleep better, you may want to know that one of the duties of the federal Pension and Welfare Benefits Administration is to ensure that all employers and 401(k) trustees follow government requirements. That’s not as good as a guarantee, but it’s better than nothing.

When I Retire?  If you have a 401(k) and retire, you will likely have four choices (assuming you are over 59 1/2).  Those choices will be: 

1. Taking the money in a lump sum. If you do, you’ll owe income taxes on all of it. The disadvantage is that after you’ve taken the lump-sum distribution, your money is no longer in a tax-deferred retirement account. That means that the only way to avoid tax on any future earnings is to invest it in tax-exempt instruments. 

2. Rolling your entire balance into an IRA. Then you can take out money as you need it, paying income taxes only on the amount you withdraw. This gives you more flexibility than any other option. Most of your money will continue to be sheltered in a tax-deferred account. You’ll have a nearly unlimited choice of investments, too. 

3. Taking a 401(k) payout as a lifetime annuity. Not all plans offer this. An annuity pays a monthly benefit for your lifetime alone or, if you choose a joint-and-survivor annuity, for your lifetime and your spouse’s. The advantage of an annuity is that it provides a guaranteed lifetime benefit. The disadvantage is that, because it’s a fixed amount, its purchasing power will be reduced every year by inflation. 

4. Leaving some or all of the money in your 401(k). You must have at least $5,000 in your account to do this. This choice makes little sense, however, since, if you like the investments available in the plan, you can use those same investments in your own IRA and completely control you access to your money. If you leave it with the plan, you’ll need to comply with the plan administrator’s rules and procedures for making withdrawals or changing investments.

If I Pass On?  One of the first things you are supposed to do when you join a 401(k) is to designate a beneficiary who will receive the money in your account when you die. If you somehow failed to designate a beneficiary, your estate will automatically become the beneficiary. If your beneficiary is your spouse, he or she will have most of the same options with the money that you would have if you were leaving the company to take another job. Your spouse could roll the money over into an Individual Retirement Account (IRA), or withdraw it all and pay income taxes on it. If your spouse decides to roll the money over into an IRA, the rollover should be direct from the employer to the IRA account. This prevents deduction of any withholding tax. If your survivor decides to withdraw the cash and pay the taxes, the Internal Revenue Service will waive its early withdrawal penalty regardless of the spouse’s age. Importantly, though, your spouse will probably not have the right to keep the money invested in the same 401(k) plan. Even more restrictions would be placed on your beneficiary if the beneficiary is not your spouse. For example, the beneficiary couldn’t roll the money over into an IRA. Most plans provide for full vesting when you die, so any matching contributions made by your employer would likely be included in the distribution to your beneficiary.

If I Become Disabled?  If you are completely disabled and cannot work, you can tap your 401(k) plan without being charged a 10 percent penalty regardless of your age. However, you will owe ordinary income taxes on the money you withdraw. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you’re disabled, you may also be able to take out any matching contributions your employer made even if you haven’t completed the years of service normally required for vesting. Most plans provide for full vesting whenever a participant becomes disabled. But each plan has its own definition of what’s required to qualify for disability. Ask your human resources or personnel department about your plan’s rules. "If your plan does provide full vesting for disabled employees and your employment is terminated as a result of a qualifying disability, you’ll receive your vested account balance-your contributions and your employer’s contributions and what they earned. If your plan doesn’t have a disability feature, or if you don’t meet the plan’s definition of disability, your distributions from the plan will be processed the same as those of other former employees."

Dividends on Employer Stock:  Corporations often pay out the dividends on the employee stock portion of their 401(k) plans because doing so can provide the companies with an important tax break. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Under the Internal Revenue Code, dividends paid on employer stock held in a 401(k) plan are fully deductible to the corporation if paid directly to the employee and are fully taxable to the employee. Therefore, the corporation may want to take this option to get a current year tax deduction."

College Financial Aid and My 401K:  One commonly overlooked benefit of making the maximum annual contribution to a 401(k) retirement plan is that it can boost your child’s chances of getting financial aid when it’s time to go off to college.   Increasing your 401(k) contributions to the maximum level might make it easier to qualify for financial aid because these balances are excluded from most college-aid calculations and reduce your taxable income at the same time. Earnings within such plans accumulate on a tax-deferred basis and may be borrowed under certain exacting standards for your children’s education. Interest that you pay back to your account is not tax-deductible, but does accrue to your account balance. You should make sure your plan allows borrowing if you consider this alternative.   Before you take this approach you should check out your plan’s loan rules. Some plans don’t allow loans, and some plans have very restrictive provisions that may invalidate this idea.

Asset Protection ~ Bankruptcy and The 401K:  The U.S. Supreme Court has held that savings in a qualified retirement plan, such as a 401(k) or IRA, are exempt from creditor claims in a bankruptcy.  However, courts have allowed the IRS to invade plan assets to recoup amounts owed by the plan participant. In fact, ERISA (the comprehensive pension law enacted in 1974) does not protect plan assets from IRS claims against a participant’s qualified plan or IRA account.

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