The 401(k) plan is a type of employer-sponsored retirement plan in the United States and some other countries, named after a section of the U.S. Internal Revenue Code. A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or "deferred", into his or her 401(k) account. 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. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.

All assets in 401(k) plans are tax deferred. Before the January 1, 2006 effective date of the designated Roth account provisions, all 401(k) contributions were on a pre-tax basis (i.e., no income tax is withheld on the income in the year it is contributed), and the contributions and growth on them are not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k). Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed). In addition to Roth and pre-tax contributions, some participants may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax basis and may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account are taxed as ordinary income.

Details

As an employee benefit, a 401(k) must be sponsored by an employer, typically a private sector corporation. A self-employed individual can set up a 401(k) plan, and, until 1986, a government entity could do so as well. The employer is responsible for creating and designing the plan. And while ERISA (Employee Retirement Income Security Act of 1974) defaults reporting and disclosure to the plan sponsor, there is no default for, and the plan sponsor must either identify at least one "named fiduciary" in the plan document or it must write a procedure into the plan for appointing the named fiduciary. While ERISA defaults total discretion and control over plan assets and investments to the plan's trustee, many plan sponsors override this default structure by giving responsibility for selecting and monitoring plan investments to the named fiduciary, often a committee of internal employees, or a mix of internal employees and outside persons bringing in particular fiduciary expertise.

A 401(k) plan is technically a type of profit sharing plan (under the IRS's definition) with a qualified Cash or Deferred Arrangement and differs from a traditional pension plan or defined benefit plan because contributions are voluntary and neither benefits nor contributions are defined. Although profit sharing plans are not pension plans, they and defined contribution plans are both called individual account plans because each participant's benefit is the value of an individual account. (Note: despite the classification, a 401(k) need not involve profit-sharing.)

In addition, 401(k) plans are tax-qualified plans covered by ERISA such that assets held by the plans are generally protected from creditors of the account holder, which in the past was generally not true for IRA plans. In the case of employer bankruptcy, 401(k) plans are also protected, while assets in a pension plan are not. Even though pension plans are backed by insurance through the Pension Benefit Guaranty Corporation, workers whose company enters bankruptcy may not receive the full value of their pension. ERISA protection of 401(k) assets does not extend to losses in the value of investments that participants choose. Employees investing their 401(k) in their own employer stock face the possibility of losing the value of their retirement accounts that is invested in employer stock along with their jobs if their employer goes out of business.

Defined benefit plans have a definitely determinable benefit amount that usually has a fixed formula, regardless of how the underlying plan assets perform. Defined contribution plans according to Section 414(i) of the IRC have individual accounts. Because plan sponsors want to take advantage of the exemption from the fiduciary duty to diversify plan assets to minimize the risk of large losses by using ERISA Section 404(c), these plans usually provide each worker the ability to control the contents of his account. The account value may fluctuate in value based on the underlying investments. There is a risk that returns may even be negative.

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 or just contribute a fixed percentage of wages. 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 the April 1st of the calendar year after the attainment of age 70½ (except that under SBJPA 1996, those still employed can defer). In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, when the employee leaves the company, the account can be rolled over into an IRA at an independent financial institution, or 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.

Comparable types of salary-deferral retirement plans include 403(b) plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and 457 plans which cover employees of state and local governments and certain tax-exempt entities.

Significant new rules are allowing benefits companies (Plan Providers) and those involved in selling benefits to plans (Plan Advisors) to expand their capabilities to sell services to Plan Sponsors (those responsible for managing employer-sponsored retirement plans for companies).

[edit] Tax consequences

Most 401(k) contributions are on a pre-tax basis. Starting in the 2006 tax year employees can either contribute on a pre-tax basis or opt to utilize the Roth 401(k) provisions to contribute on an after tax basis and have similar tax effects of a Roth IRA. However, in order to do so, the plan sponsor must amend the plan to make those options available. With either pre-tax or after tax contributions, earnings from investments in a 401(k) account (in the form of interest, dividends, or capital gains) are not taxable events. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over long periods of time.

For pre-tax contributions, the employee does not pay federal income tax 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 only recognizes $47,000 in income on that year's tax return. In 2004, this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket and there were no other adjustments (e.g. deductions). The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement. The character of any gains (including tax favored capital gains) are transformed into "ordinary income" at the time the money is withdrawn.

For after tax contributions to a designated Roth account (Roth 401(k)) qualified distributions can be made tax free. To qualify, distributions must be made more than 5 years after the first designated Roth contributions and not before the year in which the account owner turns age 59 and a half, unless an exception applies as detailed in IRS code section 72(t). In the case of designated Roth contributions, the contributions being made on an after tax basis means that the taxable income in the year of contribution is not decreased as it is with pre-tax contributions. Roth contributions are irrevocable and cannot be converted to pre-tax contributions at a later date. Administratively Roth contributions must be made to a separate account, and records must be kept that distinguish the amount of contribution that are to receive Roth treatment.

[edit] Withdrawal of funds

Virtually all employers impose severe restrictions on withdrawals while a person remains in service with the company and is under age 59½. Any withdrawal that is permitted before age 59½ is subject to an excise tax equal to ten percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year). The tax code legally defines hardship as:

1. Purchase of a primary residence (specifically excludes mortgage payments)
2. To avoid foreclosure of, or eviction from, primary residence
3. Payment of secondary education expenses incurred in the last 12 months for the employee, his/her spouse, or dependent(s)
4. Medical expenses not covered by insurance for employee, their spouse, or dependent(s) which would be deductible on a federal tax return (e.g. non-essential cosmetic surgery would not be acceptable)
5. Funeral expenses for the employee's deceased parent(s), spouse, child(ren), or dependent(s) (as of December 31, 2005)
6. Home repairs due to a deductible casualty loss (as of December 31, 2005)

In any event any amounts are subject to normal taxation as ordinary income. Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan would have to resign from their employer. To maintain the tax advantage for income deferred into a 401(k), the law stipulates 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 ½ years of age. Money that is withdrawn prior to 59 ½ typically incurs a 10% penalty tax 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's total and permanent disability, 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). This does not apply to the similar 457 plan.

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 in accordance with section 72(p) of the Internal Revenue Code. This section requires, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal.

Loans are paid back by post-tax monies, so there are substantial tax implications in taking a loan from pre-tax monies.

[edit] Required minimum distributions

Account owners must begin making distributions from their accounts at least in the year after the year they turn 70 and one half. The amounts are based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. Required minimum distributions apply to both pre-tax and after-tax Roth contributions. Only a Roth IRA is not subject to minimum distribution rules. Other than the exception for continuing to work after age 70 and a half differs from the rules for IRA minimum distributions. The same penalty applies to the failure to make the minimum distribution. The penalty is 50% of the amount that should have been distributed, one of the most severe penalties the IRS applies.

[edit] History

In 1978, Congress amended the Internal Revenue Code to add section 401(k). Work on developing the first plans began in 1979 (see History of 401(k) Plans: An Update, February 2005). Originally intended for executives, section 401(k) plans 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, if applicable, offered the employer's stock as an investment choice. Several major corporations amended existing defined contribution plans immediately following the publication of IRS proposed regulations in 1981.

A primary reason for the explosion of 401(k) plans is that such plans are cheaper for employers to maintain than a pension for every retired worker. With a 401(k) plan, instead of required pension contributions, the employer only has to pay plan administration and support costs if they elect not to match employee contributions or make profit sharing contributions. In addition, some or all of the plan administration costs can be passed on to plan participants. In years with strong profits employers can make matching or profit sharing contributions, and reduce or eliminate them in poor years. Thus 401(k) plans create a predictable cost for employers, while the cost of defined benefit plans can vary unpredictably from year to year.

[edit] Technical details

[edit] Contribution Limits

There is a maximum limit on the total yearly employee pre-tax salary deferral. The limit, known as the "402(g) limit", is $15,500 for the year 2007 [2]. For future years, the limit will be indexed for inflation, increasing in increments of $500. Employees who are 50 years old or over at any time during the year are now allowed additional pre-tax "catch up" contributions of up to $5,000 for 2006 and 2007. The limit for future "catch up" contributions will also be adjusted for inflation in increments of $500. In eligible plans, employees can elect to have their contribution allocated as either a pre-tax contribution or as an after tax Roth 401(k) contribution, or a combination of the two. The total of all 401(k) contributions must not exceed the maximum contribution amount.

If the employee contributes more than the maximum pre-tax limit to 401(k) accounts in a given year, the excess must be withdrawn by April 15th of the following year. This violation most commonly occurs when a person switches employers mid-year and the latest employer does not know to enforce the contribution limits on behalf of their employee. If this violation is noticed too late, the employee may have to pay taxes and penalties on the excess. The excess contribution, as well as the earnings on the excess, is considered "non-qualified" and cannot remain in a qualified retirement plan such as a 401(k).

Plans set up under section 401(k) can also have employer contributions that (when added to the employee contributions) cannot exceed other regulatory limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, which is the lesser of 100% of the employees compensation or $44,000 for 2006 and $45,000 for 2007. Employer matching contributions can be made on behalf of designated Roth contributions, but the employer match must be made on a pre-tax basis.^[1]

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).

[edit] Highly Compensated Employees (HCE)

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 enforced via "non-discrimination testing". Non-discrimination testing takes the deferral rates of "highly compensated employees" (HCEs) and compares them to non-highly compensated employees (NHCEs). An HCE is defined as an employee with compensation of $100,000 or greater in 2006 and remains unchanged for 2007. However, as an option prior year compensation can be used in this testing, and often is. That is for plans whose first day of the plan year is in calendar year 2007, we look to each employee's prior year gross compensation (also known as 'Medicare wages') and those who earned more than $100,000 are HCEs. Most testing done now in early 2006 will be for the 2005 plan year when we compare employees' 2004 plan year gross compensation to the $90,000 threshold for 2004 to determine who is a HCE and who is a NHCE.

The average deferral percentage (ADP) of all HCEs, as a group, can be no more than 2% greater (or 150% of, whichever is less) than the NHCEs, as a group. This is known as the ADP test. When a plan fails the ADP test, it essentially has two options to come into compliance. It can have a return of excess done to the HCEs to bring their ADP to a lower, passing, level. Or it can process a "qualified non-elective contribution" (QNEC) to some or all of the NHCEs to raise their ADP to a passing level. The return of excess requires the plan to send a taxable distribution to the HCEs (or reclassify regular contributions as catch-up contributions subject to the annual catch-up limit for those HCEs over 50) by March 15th of the year following the failed test. A QNEC must be an immediately vested contribution.

The annual contribution percentage (ACP) test is similarly performed but also includes employer matching and employee after-tax contributions. ACPs do not use the simple 2% threshold, and include other provisions which can allow the plan to "shift" excess passing rates from the ADP over to the ACP. A failed ACP test is likewise addressed through return of excess, or a QNEC or qualified match (QMAC).

There are a number of "safe harbor" provisions that can allow a company to be exempted from the ADP test. 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 with immediate eligibility for employees. There are other administrative requirements within the safe harbor, such as requiring the employer to notify all eligible employees of the opportunity to participate in the plan, and restricting the employer from suspending participants for any reason other than due to a hardship withdrawal.

 

[edit] 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 salary 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 make an "elective deferral" of $15,000 plus a profit sharing contribution of $25,000 (i.e 25%), and — if this person is over age 50 — make a catch-up contribution of $5,000 for a total of $45,000. For those eligible to make "catch up" contribution,and with salary of $136,000 or higher, the maximum possible total contribution in 2006 would be $49,000 ($50,000 in 2007). To take advantage of these higher contributions, many vendors now offer Solo-401(k) plans or Individual(k) plans.

Note: an unincorporated business person is subject to slightly different calculation. The government mandates calculation of profit sharing contribution as 25% of net self employment (Schedule C) income. Thus on $100,000 of self employment income, the contribution would be 20% of the gross self employment income, 25% of the net after the contribution of $20,000.