What You Should Know About 401k Plans

Bits of What You Probably Should Know of 401 (k) Plans

--- The term 401 (k) is one that is heard quite often in today's. Most people know that it has something to do with retirement, but few young people know exactly how 401 (k) plans work or why they are becoming more and more popular. Additionally, many people who have 401 (k) plans may not know all the details of how they work, how to get the most out of their plan, and how to keep their money safe. In reality, everyone in the business world should be aware of the details and advantages of having and managing a 401 (k) type savings plan, as it is becoming one of the most popular ways to save for retirement in the United States and many other countries.

First, it is imperative to understand the basics of the 401 (k). By definition, a 401(k) plan is an employee funded retirement savings plan that is set up and sponsored by the employer. They are considered individual account plans because each participant's benefit is the value of a separate personal account (401 (k) - Wikipedia). All 401 (k) plans are funded by employee contributions and usually also include matching contributions from the company.

The history of the 401(k) plan begins with an amendment to the Internal Revenue Code (IRC) by Congress which added section 401(k), after which the plan is named. The Revenue Act of 1978 added provisions to the Internal Revenue Code, which included allowing the use of "salary reductions" as a source of plan contributions (McDonnell, 1). Basically, this meant that employees could defer part of their salary into their account, also decreasing their taxable income. The law went into effect in January of 1980 and more regulations were issued in 1981. Shortly thereafter, many companies started the process of adopting 401(k) plans and, by the mid 1980s, nearly half of all large firms already had or were considering 401(k) plans (McDonnell, 1). One of the first companies to begin planning to adopt the 401 (k) even before regulations were issued in 1981 was Johnson & Johnson (Whitehouse, 1). Additional companies that began to develop plan proposals between 1979 and 1982 included, PepsiCo, JC Penney, FMC, Honeywell, and Hughes Aircraft Company (McDonnell, 2).

Interestingly, the 401(k) was originally intended for executives, but quickly became popular with employees on all levels because it had a few notable benefits over the already popular Individual Retirement Accounts (IRAs), which included higher contribution limits, and employer matches (401 (k) - Wikipedia). Over the last twenty years, the 401(k) has grown in popularity and by the end of 2003, had over forty million participants and almost two trillion in total assets (McDonnell, 1). See Fig. 1-1 and 1-2 for 401 (k) growth analyses.

There are maximum contribution limits for 401 (k) plans which are determined by the Internal Revenue Service. For example, the annual limit for 2007 is fifteen thousand dollars, and this limit is evaluated and increased in five hundred dollar increments (The basics of a 401(k) plan). Also, those over fifty years old can make catch up contributions in addition to their normal contributions.

In a normal 401(k) the funds are taken from pre tax salary, and federal income tax is not paid until the money is withdrawn (Neiters). Each type of plan has its own advantages which will be discussed later. There are also strict regulations regarding how and when the money in a 401(k) can be withdrawn. According to the Internal Revenue Service, "distributions of elective deferrals cannot be made until one of the following occurs: the participant reaches age fifty-nine and one half, the participant dies, becomes disabled, or otherwise has a severance from employment, or the plan terminates and no successor defined contribution plan is established or maintained by the employer." The terms of the plan determine whether the distributions are nonperiodic, such as lump-sum distributions or periodic, such as annuity or installment payments (Internal Revenue Service). If withdrawals are made before this time, a penalty of ten percent of the taxable amount of the withdrawal is assessed. There are some cases, however, where there are exceptions . Some exceptions may include leaving your employer at age fifty-five or older, purchase of a primary residence, to avoid foreclosure of or eviction from a primary residence, and medical expenses not covered by insurance (The basics of a 401(k) plan). If a person chooses to wait to begin taking money from their account, they must begin making required minimum distributions by the year after they turn seventy and one half. The notable exception is for those still working at this age (401 (k) - Wikipedia).

There are many advantages of 401 (k) plans, both for employees and their employers. One major important benefit is that the employee has control over how much money they contribute to their account. In addition all employer contributions and any growth in the capital grow tax-free until withdrawal. If the company matches contributions, it's like getting extra money on top of your salary. Also, unlike a pension, all the savings can be moved from one company's plan to the next (or to an individual retirement account) if a participant changes jobs (Neiters). Another benefit can be that employees can reduce their taxes because they are reducing their taxable income while they are working and because they will be in a lower tax bracket when they begin making distributions. "The major cause for the huge popularity of the 401(k) plan is virtue of the plan being considerably cheaper for the employers to maintain than a pension for every retired employee (History of the 401K Retirement Plan)." There are also a few disadvantages of 401 (k) plans however. It is difficult and costly to 401(k) before the defined age, employer matching contributions are usually not vested (i.e., do not become the property of the employee) until a number of years have passed (Neiters).

One extremely important aspect of the 401(k) plan is how the money is protected. There are guidelines for how money in 401(k)s is maintained established in 1974 by the Employee Retirement Income Security Act (ERISA). The most important fact is that "a 401(k) plan account is not considered an asset of the employer as it is held in trust in a separate account. This means that retirement plan money is not commingled with the company's money. In addition the company cannot access the plan money for any purpose related to maintaining its business (The basics of a 401(k) plan)." In addition, 401(k) plans are generally protected from creditors of the account holder and are also protected in the case of employer bankruptcy (401 (k) - Wikipedia). The main aspect which is not covered