Since its inception in 1978, the 401(k) plan has grown to be the most popular type of employer sponsored retirement plan in America. Millions of workers depend on the money that they have saved in this plan to provide for their retirement years, and many employers use their 401(k) plans as a means of distributing company stock to employees. Few other plans can match the relative flexibility that 401(k)s offer. In recent years, several variations of this plan have emerged, such as the SIMPLE 401(k) and the safe-harbor 401(k). Here, we'll go over 401(k)s and show you how they are helping millions of people prepare for retirement. (For background reading, see the 401(k) and Qualified Plans Tutorial.)
What Is a 401(k) Plan?
By definition, a 401(k) plan is an arrangement that allows an employee to choose between taking compensation in cash or deferring a percentage of it to an account under the plan. The amount deferred is usually not taxable to the employee until it is withdrawn or distributed from the plan. However, if the plan permits, an employee can make 401(k) contributions on an after-tax basis, and these amounts are tax-free when withdrawn. 401(k) plans are a type of retirement plan known as a qualified plan, which means that this plan is governed by the regulations stipulated in the Employee Retirement Income Security Act of 1974 and the tax code.
Qualified plans can be divided two different ways: they can be either defined-contribution or defined-benefit plans. 401(k) plans are a type of defined-contribution plan, which means that a participant's balance is determined by contributions made to the plan and the performance of plan investments. The employer is usually not required to make contributions to the plan as is usually the case with a pension plan. However, many employers choose to match their employees' contributions up to a certain percentage, and/or make contributions under a profit-sharing feature. (For related reading, see The Demise Of The Defined-Benefit Plan.)
For 2013, the maximum amount of compensation that an employee can defer to a 401(k) plan is $17,500. Employees age 50 by the end of the year and older can also make additional catch-up contributions of up to $5,500. The maximum allowable employer/employee joint contribution limit remains at $51,000 for 2013 (or $56,500 for those aged 50 and older). The employer component includes matching contributions, nonelective contributions and/or profit-sharing contributions.
Typically, plan contributions are invested in a portfolio of mutual funds, but can include stocks, bonds and other investment vehicles as permitted under the provisions of the governing plan document.
The distribution rules for 401(k) plans differ from those that apply to IRAs. The money inside the plan does grow tax-deferred as with IRAs, but whereas IRA distributions can be made at any time, a triggering event must be satisfied in order for distributions to occur from a 401(k) plan. As a result, 401(k) assets can usually be withdrawn only under the following conditions:
- Upon the employee's retirement, death, disability or separation from service with the employer
- Upon the employee's attainment of age 59.5
- The employee experiences a hardship as defined under the plan, if the plan permits hardship withdrawals
- Upon the termination of the plan
Required minimum distributions (RMDs) must also begin at age 70.5, unless the participant is still employed and the plan allows RMDs to be deferred until retirement. Distributions will be counted as ordinary income and assessed a 10% early distribution penalty if the distribution occurs before age 59.5 unless an exceptions applies. Exceptions include the following:
- The distributions occur after the death or disability of the employee.
- The distributions occur after the employee separates from service, providing the separation occurs during or after the calendar year that the employee attains age 55.
- The distribution is made to an alternate payee under a qualified domestic relations order (QDRO). (For more on this, see Getting A Divorce? Understand The Rules Of Dividing Plan Assets.)
- The employee has deductible medical expenses exceeding 7.5% of adjusted gross income.
- The distributions are taken as a series of substantially equal periodic payments over the participant's life or the joint lives of the participant and beneficiary. (See Rules Regarding Substantially Equal Periodic Payment (SEPP) to learn more.)
- The distribution represents a timely correction of excess contributions or deferrals.
- The distribution is as a result of an IRS levy on the employee's account.
- The distribution is not taxable.
The exceptions for higher education expenses and first-time home purchases only apply to IRAs.
Of course, the majority of retirees who draw income from their 401(k)s choose to roll over the amounts to a Traditional IRA or Roth IRA. A rollover allows them to escape the limited investment choices that are often presented in 401(k) accounts. Employees who have employer stock in their plans are also eligible to take advantage of the "net unrealized appreciation" rule (NUA) and receive capital gains treatment on the earnings. (See Rolling Over Company Stock: A Decision To Think Twice About.)
Plan loans are another way that employees can access their plan balances, but several restrictions apply. First, the loan option is available at the employer's discretion; therefore, if the employer chooses not to allow plan loans, then no loans will be available. If this option is allowed, then up to 50% of the employee's vested balance can be accessed, providing the amount does not exceed $50,000, and it must usually be repaid within five years. However, loans used for primary home purchases can be repaid over longer periods. The interest rate must be comparable to the rate charged by lending institutions for similar loans. Any unpaid balance left at the end of the term may be considered a distribution and will be taxed and penalized accordingly. (For more on loans, see Should You Take A Loan From Your Plan? and Eight Reasons To Never Borrow From Your 401(k).)
Limits for High-Income Earners
For most rank-and-file employees, the dollar contribution limits are sufficiently high enough to allow for adequate levels of income deferral. But the dollar contribution limits imposed on 401(k) plans can be a handicap for employees who earn several hundred thousand dollars a year. For instance, an employee who earns $750,000 in 2013 can only include the first $255,000 of income can be considered when computing the maximum possible contributions to a 401(k) plan. Employers have the option of providing nonqualified plans, such as deferred compensation or executive bonus plans for these employees in order to allow them to save additional income for retirement.
The Bottom Line
401(k) plans will continue to play a major role in the retirement planning industry for years to come. In this article, we have only touched on the major provisions of 401(k) plans. For more specific information on the options available to you, check with your employer and plan provider.