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.
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 Taxes are payable when the assets are withdrawn, usually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.
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
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?
flows into a 401(k) plan through:
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.
Matching Contributions: 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.
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.
the carrier managing your 401(k) plan, employees can select from
up to 30 or more various fund options for investment of their 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.
are always 100% vested immediately; terminated employees always
have 100% ownership of their own contributions.
contributions and employer discretionary contributions are vested
according to a schedule determined by the employer when the plan
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.
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.