401(k)

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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.

1 Details
2 Tax consequences
3 History
4 Technical details
5 401(k) plans for certain small businesses or sole proprietorships
6 Other countries
7 See also
8 External links

[edit] 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 acts as a plan fiduciary and is responsible for creating and designing the plan, as well as selecting and monitoring plan investments. (In practice, nearly all employers outsource all of this work to one or more financial services companies, such as a bank, mutual fund, third party administrator, or insurance company.)

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 the Employee Retirement Income Security Act of 1974 (ERISA), so 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 after the calendar year of 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

Starting in the 2006 tax year, employees can opt to use the Roth 401(k), Roth 403(b) to have the same tax effects of a Roth IRA. However, in order to do so, the plan sponsor must amend the plan to make those options available. Therefore, the following discussion does not involve Roth 401(k) accounts unless specified.

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).

Furthermore, 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.

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. Many people assume that a 401(k)'s main advantage is due to the employee being in a lower tax bracket in retirement than during working years, but this assumption is not always realistic or guaranteed to be correct, because the current capital gain rate is 15% while the marginal income tax rate on ordinary income may be as high as 35%. Given the long-term budget outlook and its inherent uncertainty, the ordinary income tax rate could once again rise to 35% or higher.

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:

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

[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

There is a maximum limit on the total yearly employee pre-tax salary deferral. The limit, known as the "402(g) limit", is $15,000 for the year 2006 and $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.

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 qualifed 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.

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).

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 threhold 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 "qualifed 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 compensation 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 defer $15,000, make 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, though this would be limited in 2006 to $44,000, the maximum allowed under the higher IRC-415 limit.

To take advantage of these higher contributions, many vendors now offer Solo-401(k) plans or Individual(k) plans.

[edit] Other countries

The term "401(k)," a reference to an obscure provision of the U.S. Internal Revenue Code, has become so well-known that other countries are using it to describe similar legislation. For example, in October 2001, Japan adopted legislation allowing the creation of "Japan-version 401(k)" accounts even though no provision of the relevant Japanese codes is in fact called "section 401(k)."

However, in countries such as India and Singapore, the equivalent of the U.S. 401(k) plans are referred to as Provident Funds.