401(k) Plan Basics

You’ve recently been approached by your company asking about your participation in their 401(k) plan. While you’ve heard the term, you are uncertain what it all means. A “401(k) Plan” is actually a type of deferred profit sharing plan that adds the Internal Revenue Code’s (IRC) Section 401(k) language to allow employees to contribute a portion of their wages on a pre-tax basis through a salary reduction agreement to a qualified retirement plan. That’s admittedly a mouthful so let’s break it down:

Deferred Profit Sharing Plan. A type of company retirement plan that allows a company to contribute a portion of its profits into separate accounts for employees. These contributions are discretionary (meaning the company isn’t required to make them each year), however according to the IRS, they must be “substantial and recurring.” The contributions are also excluded from federal and state income tax to the employee, grow tax-deferred during the employee’s working lifetime, and are taxed as ordinary income at the time money is drawn from the account (typically in retirement).

IRC. The Internal Revenue Code (IRC) is the set of tax laws created by the Internal Revenue Service (IRS).

Employee Pre-Tax Contributions. Using a “salary reduction agreement,” a type of Cash Or Deferred Arrangement (CODA), employees that participate in a 401(k) plan elect to have a portion of their wages placed into their individual retirement plan accounts. Similar to the employer profit sharing contributions, these employee deferrals are made before calculating an income tax (offering the employee a lower earned income on his or her W-2 and a resulting smaller income tax bill). Also like the employer contributions, these deferrals grow tax-free and are only taxed when funds are withdrawn.

Qualified Retirement Plan. A type of employer-sponsored retirement plan that meets all of the requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and are subsequently allowed to offer tax breaks to both the employee and participating employees.

In summary, both the employer and employee may contribute to the employee-participant’s 401(k) plan account. As an incentive many employers further offer to match employee contributions up to a specified percentage. For example, let’s say that a firm matches 100% up to the first 3% of employee contributions. In a given year, employee A, making $30,000, elects to defer 5% ($1,500). The company would match the first 3% ($900). Employee B makes the same salary, but instead chooses to only contribute 2% ($600). Here the company would also contribute 2% ($600). In this example, employee A would have a $2,400 account balance as compared to employee B’s $1,200. It’s easy to see why any employee should contribute at least up to the company match and take advantage of the free money.

401(k) plans also have a number of features that need to be understood by participants. Among these, terms such as Eligibility, Vesting, Distributions, and Roth are some of the more important. Eligibility is the set of rules that allow an employee to participate in a given company plan. The most common eligibility is “21 and one” which requires that an employee attain 21 years old and have worked for the firm for a full year (further defined as 1,000 hours of service). Vesting refers to the ownership of the money in a participant’s account. All employee contributions, account investment earnings, and discretionary employer profit sharing contributions are always 100% vested – meaning they are always owned by the employee. Company matching contributions, however, may be subject to a vesting schedule. Two common schedules are a 3-year cliff vesting whereby the employer contributions are not owned by the employee until after 3 full years of service following the date of the contributions. A 2-to-6 year graded schedule is the common alternative. In this case, the employee owns 20% of the employer matching contributions after 2 full years of service, 40% after 3 years, and up to 100% after 6 years. Distributions are withdrawals from a participant’s account. These come in two formats; loans and hardship withdrawals. Loans are typically for a period of five years or less and allow a participant to temporarily draw fund from an account. They are subject to a reasonable rate of interest. Hardship withdrawals require “an immediate and heavy financial need” and may be used for funeral expenses, certain medical expenses, purchase of a primary residence, or postsecondary education costs. Both types of distributions may or may not be offered in a given plan and details for each are spelled out in the Summary Plan Description document. In either case, even if available, these should be used as a last resort as reducing the funds within an account will additionally reduce the opportunity for compounding and could have severe negative effects on the participant’s account at retirement time. The last notable item, Roth, is a relatively new option (part of the Economic Growth and Tax Relief Reconciliation Act of 2001, EGTRRA). When available in a plan, it allows a participant to pay taxes on the employee deferral 401(k) contributions now, let the money grow tax-free, and take retirement withdrawals completely tax free. This is commonly seen as wise option for participants currently in a low tax bracket as well as those who are younger and have more time to let the money grow.

A 401(k) plan is a great way to help employees save for retirement. Once the funds are in the account, decisions need to be made as to how best to allocate the funds. Investment alternatives and asset allocation are other topics that will be addressed in another article. Suffice it to say, however, for most American workers today, prudent funding of a 401(k) account is key to a financially-secure retirement.