401(k) Plans
A 401(k) plan is an employer-sponsored, qualified retirement plan. Under a 401(k) plan, employees can defer income taxes on their earnings by electing to contribute to the plan. Income taxes are also deferred on employer contributions made to the plan on behalf of employees. These special tax treatments earn the 401(k) plan the designation of a "qualified plan." This "cash or deferred arrangement" (CODA) is made possible by Section 401(k) of the Internal Revenue Code.
What are the benefits of a 401(k) plan to employees?
- Tax Savings: Employees save on a pretax basis. The amount they contribute is deducted from their current federal (and, in most cases including California, state and local) taxable income. Plus, payroll deduction is an easy, convenient way to save.
- Tax Deferral: Employer matching contributions and discretionary contributions are not included in current taxable income to the employee. In addition, interest accumulates on all contributions on a tax-deferred basis. Taxes are payable when the assets are withdrawn, usually at retirement when the employee is in a lower tax bracket.
- Diversification and Flexibility: Employees can elect to participate in the plan at their own comfort levels. Contributions can be increased or decreased, may be stopped if necessary and can be rolled over into another retirement plan by participants at termination of employment.
- Providing Financial Security: Most employees lack confidence in the Social Security system to provide for them during their retirement as it has for past generations. Participation in a 401(k) plan ensures employees a means to provide for their own future financial needs. In addition, ERISA usually protects pension assets from creditors in the event of personal or business bankruptcy.
How does a 401(k) plan work?
Money flows into a 401(k) plan through:
- Voluntary Employee Contributions: Employees elect to have money deducted from their paychecks to invest in the plan. The amounts are either a fixed percentage of salary or a flat dollar amount per pay period.
- Employer Matching Contributions (optional): Employers may offer to match employee contributions. The contribution takes the form of an employer match on the employee contribution. A typical method is for the employer to provide a $.25 or $.50 for each dollar contributed by each employee. This encourages the employees to participate and contribute to the 401(k) plan.
- Employer Discretionary Contributions (Optional): This option must be written into the plan when the plan is adopted. A discretionary contribution is one that is made at the employer's discretion, usually at the end of the plan year. Often times, the employer will use this vehicle to provide employees with a profit-sharing plan after a good business year and/or when the employer is looking for additional tax deductions.
Will a 401(k) plan cover all of my employees?
The employer determines when employees are eligible to participate in the 401(k) plan. However, nondiscrimination requirements set by the IRS will not allow a qualified retirement plan from requiring that an employee complete a period of service beyond the later of age 21 or one year of service. Also, employees cannot be excluded to a maximum age.
How are 401(k) plan assets invested?
There are many different 401(k) plans offered through various insurance companies and financial institutions, each with their own selection of investment funding options including well-known mutual fund families and guaranteed/fixed accounts.
Depending on the carrier managing your 401(k) plan, employees can select from up to 30 or more various fund options for investment of their contributions.
Employee contributions, employer matching contributions and employer discretionary contributions are all invested in the same manner; each employee decides what percent of the total contributions from all of these sources will be invested in any number of the investment fund options. Individual records on the sources and amounts of contributions and investment performance are kept for each participant.
An account statement, showing the allocation of plan assets and performance of each of the investment options, account balances and other activities, is mailed to each participant at least once every quarter.
What is vesting and how does it apply to a 401(k) plan?
Vesting refers to the percentage of actual ownership that participants have in their 401(k) plan accounts.
If a participant terminates employment, any funds that are not vested are forfeited back to the plan and may be reallocated among other plan participants or used to reduce future employer contributions.
Employee contributions are always 100% vested immediately; terminated employees always have 100% ownership of their own contributions.
Employer matching contributions and employer discretionary contributions are vested according to a schedule determined by the employer when the plan is adopted.
Can an employee change or stop contributions to the 401(k) plan?
An employee can stop making contributions to a 401(k) plan at any time. A typical plan will allow employees to start making contributions or change the amount of their contributions at least every quarter.
This kind of activity is usually determined by the employer and/or the 401(k) plan provider when the plan is adopted. If an employee stops making contributions, the account will maintain its tax-sheltered status and earnings will continue to accumulate tax-deferred, unless the money is taken as a distribution.
Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with professional advice. Information is subject to change without notice.