Standard 401(K) Plan

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    What is a 401(k) plan?

    A 401(k) is a type of retirement plan that is named for a section of the tax law allowing employees to contribute a portion of their compensation, before income taxes, to a company-sponsored retirement plan. The amount the company withholds from an employee’s paycheck is called a deferral. When contributions come out of the paycheck before taxes, the employee’s taxable income is lower, and his or her tax burden is decreased.

    There are several types of 401(k) plans, including:

    • SIMPLE 401(k)
    • Safe Harbor 401(k)
    • Solo 401(k)
    • Roth 401(k)
    • Traditional 401(k)
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    What are the benefits of a 401(k)?

    With 401(k) contributions coming out of the employee’s paycheck before federal and most state income taxes are assessed, the employee will pay lower income taxes than if he or she would not have contributed to the 401(k) during the year. The contributions are invested and start earning interest and capital gains on a tax-deferred basis. When an employee starts withdrawing money from the account, (usually at retirement, when he or she may be in a lower tax bracket), he or she will pay regular income taxes on the contributions and earnings withdrawn.

    Many 401(k) plans give employers the option of matching a portion of the amount the employee invests. For example: Susan’s annual compensation is $60,000 a year, and she contributes 8 percent to her 401(k). Her annual contribution would be $4,800. If her employer matches that amount, up to 3 percent of her compensation, that’s an additional $1,800 going into Susan’s retirement savings.

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    Who may establish a 401(k)?

    Any employer is eligible to establish a 401(k). If you are self-employed, you can open a Solo 401(k).

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    Who may participate in a 401(k)?

    Employers and employees can participate in 401(k) plans. Each 401(k) document or summary plan description (SPD) outlines what the specific plan provides, who is eligible, what is required and how the plan works.

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    How do I start a 401(k)?

    1. Adopt a written plan, called the plan document, which outlines its day-to-day operations.
    2. Identify a plan provider and/or trust for its assets and investments.
    3. Select a recordkeeper or recordkeeping system to track contributions, earnings and losses, and distributions. This person or entity will also help prepare the annual return, which must be filed with the federal government.
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    401(k) Investment Options

    There are many investment options available with a 401(k) retirement plan, including mutual funds. These choices are selected by the employer, often with the help of a TPA or financial advisor. Those who participate in the plan can make decisions within the options set by the employer.

    • Objective — Plans created based on specific investment objectives, including balance, growth and preservation
    • Customized — Another option for investors to build an investment portfolio containing tax-exempt funds.
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    401(k) Employer Contributions

    As a way to encourage employees to invest their own funds, many companies choose to match those contributions. Some employers choose to match dollar for dollar, while others will contribute only a percentage of the contributions employees make. Employers sometimes also choose to make discretionary contributions.

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    401(k) Participant Contributions

    When employees participate in the plan, they get to determine the exact amount of money contributed automatically from each pay period. Individuals can typically invest up to $18,500 per year. This amount increases to $24,500 for individuals age 50 or older.

    Traditional contributions, excluding Roth contributions, are completed before tax deductions. This means that less income tax is paid when the investment is made. These taxes — including taxes on any interest earned — will be paid when the money is withdrawn.

    Some plans may allow for Roth contributions. These contributions are taxed prior to the deduction, which means that they won’t be taxed again on withdrawal. The earnings are penalty- and tax-free in some situations. Any withdrawals from Roth accounts are penalty- and tax-free for any accounts created at least five years prior to the withdrawal. The participant must also be 59½ years old, deceased or disabled. Any nonqualified distributions will result in taxable earnings that are also subject to a 10 percent early withdrawal penalty.

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    401(k) Vesting

    Employees always maintain ownership over all of the funds drawn directly from their pay; however, employer contributions may require individuals to work for a period of time before becoming fully vested in these funds.

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    401(k) Distribution

    A 401(k) retirement plan requires individuals to be at least 59½ years of age or have a qualified disability to access the funds without penalty; however, some plans may provide the opportunity to withdraw money prior to this time.

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    401(k) End-of-employment Options

    When an employee is fired or quits, there are a number of options for large and small business retirement plans:

    • Roll it over — A 401(k) retirement plan can be rolled into an IRA to allow individuals to maintain their tax benefits, avoid early withdrawal penalties and choose from a vast array of investment options. A Roth IRA can also allow for distribution, with fewer restrictions.
    • Keep the plan — If an individual has a large enough account balance, he or she may be able to keep his or her 401(k) as it is, with the same benefits. The person may see an increase in fees and will not be able to make additional contributions.
    • Transfer to a new plan — If a new employer allows for rollovers from an old account, employees may choose to transfer the funds to the new account.
    • Cash it out — For those who are not at the appropriate age for distribution, the plan may still be cashed out; however, there will be penalties and taxes that may be assessed.