The 401 (k) retirement plan came into existence back in 1978, and ever since its’ inception, has proved to be the single most popular type of plan of its kind, with no other employer-sponsored retirement plan in America able to compete with it.
The money that millions of employees have saved in these plans, are done so to enable them to provide for themselves during their retirement years, and many employers use the plan to distribute company stock to their workers.
The 401 (k) plan in its’ simplest form:
A 401 (k) can be defined as an arrangement that enables employees to select whether they take cash compensation or defer a percentage of it to a 401 (k) account under the retirement plan. If deferred the amount is generally not subject to taxes until the employee withdraws it or distributes it from the plan. That said, if the plan allows it, a worker can make 401 (k) contributions on an after-tax basis, in which the amounts when withdrawn, are usually tax free.
Regulations stipulated in the Employee Retirement Income Security Act of 1974 and the Tax Code govern the 401 (k) plan which is known as a ‘qualified plan’. Qualified plans can either be ‘defined contributions’ or ‘defined benefits’ pension plans, and 401 (k) plans are a type of defined contribution plan. This means that the person participating in the plan, has a balance determined by contributions made to the plan and the performance plan of investments. The employer isn’t required to contribute towards the plan, as is often the case with pension plans, but they often opt to match their workers’ contributions under profit sharing feature.
Limits to contributions:
At the time of writing, the most compensation that an employee can defer to a 401 (k) plan is $18,000, with workers aged 50 or above by the end of the year, able to make extra catch-up contributions of up to $6,000. The most that employer/employees can jointly contribute is $53,000, with the amount being slightly higher for those aged 50 and above.
Rules of distribution:
IRA’s have a different set of distribution rules to 401(k) plans; the money in the plan grows as tax-deferred, just as with IRA’s, but a triggering event must be applicable for distributions to occur from a 401(k), unlike with IRA’s where distributions can be made at any time. Due to this restriction, 401(k) assets can only be withdrawn under a set of conditions:
- The employee’s retirement, death, disability or separation from service with the employer
- When the employee reaches the age of 59 ½
- If the employee experiences a qualifying hardship as defined under the plan
- When the plan is terminated
For the most part, retires who draw income from their 401(k)’s, opt to roll the amounts over to traditional IRA’s or Roth IRA’s. Rollovers enable them to avoid the limited investment choices that are often presented in 401(k) accounts.
The last word on 401(k) plans:
It’s estimated that this type of plan will continue to play a major role in the retirement planning industry for the foreseeable future, and for more details about 401(k) plans, please make an appointment to speak with a professional tax advisor and have them explain it to you in further detail.