Congress amended the IRS Code to add section 401(k). Work on developing the first plans began in 1979. Originally 401(k) plan was intended for executives but plan proved popular with workers at all levels due to higher contributing limits than the IRA’s and it usually cam with a company match and provided greater flexibility. 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.
401(k) is a employer-sponsored retirement plan available for the people in US. In this plan the employee elects to have a portion of his or her salary deferred or paid directly to the 401(k) account. There are mainly two types of 401(k) plans available:
1. Participant-directed Plans: In this type of plan the employee can select from a number of investment options such as Mutual funds, Stocks, Bonds etc. Employee can invest in any vehicle he wishes. Most of the 401(k) plans today are participant-directed Plans. Many big companies also offer to purchase companies stock as a part of 401(k) plan.
2. Trustee-directed Plans: In this type of 401(k) plan the employer appoints a trustee who decides how the money contributed towards 401(k) will be invested. Employee does not have a say in this type of 401(k) Plan. This Plan is less common now a days and very few companies actually use it.
401(k) Plan is a profit sharing plan (Under IRS definition) with a qualified cash or deferred arrangement. But actual 401(k) plan may not have anything to do with profit sharing as Profit sharing is one of the part of 401(k) plan. Employee contribution can still be made in 401(k).
The Main advantage of 401(k) plan is in case of bankruptcy your 401(k) contribution are protected from creditors. Even if the company for which you have 401(k) plan declares bankruptcy your 401(k) plan is safe. Amount in your 401(k) plan is protected under Employee Retirement Income Security Act of 1974 (ERISA). In 2004 some companies started charging a fee to ex-employees who maintained there 401(k) plan with them. Due to this it is recommended that when you leave a job try to roll over your 401(k) money to either IRA or the new companies 401(k) plan.
Tax consequences and contribution limits:
As with all retirement accounts there is a set limit you can contribute towards your 401(k) plan and there is also a tax benefit associated with them. First I will talk about the Tax benefits in detail.
Here I am not going to discuss about the Roth 401(k) plan which are now started and one can contribute in it to take advantage of Roth side of 401(k). But the company has to provide it to there employees to make any contribution. Currently very few companies have started offering Roth 401(k) plan.
401(k) contributions are not taxed at the time of contribution and are allowed to grow tax free until you make your withdrawals. This is also called as tax deferred account. For people who are in a higher tax bracket while working and assume that they will be in a lower tax bracket in retirement 401(k) plan is the best investment. But sometimes it is not true of you have a lot of contribution in 401(k) and traditional IRA along with Pension you may be in same or higher bracket in retirement.
Due to all the tax benefits one gets IRS also imposes some restrictions for withdrawals from 401(k) accounts. If you withdraw from your 401(k) account before age of 591/2 while you are still working for any reasons other then listed below will be subjected to early withdrawal penalty of 10%. You can avoid the penalty if you qualify for one of the following:
1. Purchase of a primary residence (specifically excludes mortgage payments)
2. To avoid foreclosure of primary residence
3. Payment of secondary education expenses incurred in the last 12 months for the employee and his/her dependents.
4. Medical expenses not covered by Insurance and which would be deductible on a federal tax return.
5. Funeral Expenses for the employee’s parents, spouse and dependents.
6. Home repairs due to a deductible casualty loss
I would advise not to withdraw money from a 401(k) plan without talking to your tax advisor and figuring out the exact way to avoid penalty. Another catch is there is minimum distribution requirement at age 701/2 according to IRS. You can defer the minimum distribution if you are still working.
For contribution limits for 401(k) plan are set forth by IRS and are revised to take into account Inflation. Currently the contribution limits for a 401K plan is as follows:
For Year 2006 401(k) Contribution Limit: $15,000
For Year 2006 Catch up Contribution Limit: $5000 (only for those over 50 years)
For Year 2007 401(k) Contribution Limit: $15,500
For Year 2007 Catch up Contribution Limit: $5000 (only for those over 50 years)
For future years, the limit will be indexed for inflation, increasing in increments of $500.
These are the IRS limits, but you are also subject to the limits imposed by your employer. Check with employer if they have any restrictions. If there is any excess contribution made during the year it should be withdrawn from the account before April 15th.
The term “401(k)” taken from the IRS code has become so popular that other countries are using the same term for the retirement plan. 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).” In countries like Singapore and India similar plan to 401(k) are referred as Provident Funds.
401(k) plan provides a bigger contribution to you retirement nest egg and save enough for retirement. It is one of the major investment vehicle available for retirement planning and it works best with Roth IRA. If you have not started a 401(k) plan I would suggest you to talk with your employer and start one today.