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A 401k is a qualified retirement plan that allows eligible employees of a company to save and invest for their own retirement on a tax deferred basis. Only an employer is allowed to sponsor a 401k for their employees. You decide how much money you want deducted from your paycheck and deposit it to the plan based on limits imposed by plan provisions and IRS rules. Your employer may also choose to make contributions to the plan, but this is optional.

It is the employers (also called the plan sponsor) responsibility to run the plan in accordance with law, rules and regulations, and provisions of the plan itself. This includes deciding who is eligible for the plan, how much and when they can contribute, how much the employer will contribute to the plan, what investment options you will have, how often you can reallocate your investment assets, hiring the vendors necessary to run the plan, and what features the plan will have (will loans be allowed, will hardship withdrawals be allowed, etc.).

It is your responsibility to decide if you want to participate in the 401k, and if so, how much you will contribute each pay period. If you earn $750 each pay period and elect to defer 5% of your pay, $37.50 is taken out of your pay and placed in the 401k plan. These contributions are deducted from your salary on a pre-tax basis. This means that by contributing to a 401k, you actually lower the amount you pay in current income taxes. For example, instead of being taxed on the full $750 per pay period, you are only taxed on $712.50 ($750 minus your 401k contribution of $37.50 equals $712.50). You don't owe income taxes on the money contributed until you withdraw it from the plan.

Here are a couple of things to remember about 401k plans.

Don't put off participating in your 401k, even if you think you can't afford to. Time is your best guarantee that you will make your retirement goals, so the sooner you start contributing the better off you are going to be in retirement. Even just one or two percent will make a big difference.

A 401k is a retirement plan, not a savings account. Money placed in a 401k is not easy to access in an emergency. Some plans allow loans and hardship withdrawals, but the rules governing them are restrictive.  The standard age that you can access your 401k is 59.5 years old.  You can drawdown money before then but you are penalised 10%.

Employer-sponsored retirement plans are generally grouped into two major categories: defined benefit (DB) and defined contribution (DC). In a DB plan, the employer promises to pay a defined amount to retirees who meet certain eligibility criteria. In other words, the plan defines the benefit to be received. In its most typical form, a DB plan pays a lifetime monthly benefit to retirees who fulfill specific age and service requirements. Benefits are usually linked to the amount of service and based on final average salary. Employees can reasonably rely on a known and expected benefit level; although protection against post-separation inflation is usually limited and/or uncertain. The plan sponsor may also provide an alternative lump-sum "cash-out" of the benefit entitlement. Until relatively recent times, the DB was the dominant form of employer-sponsored retirement program.

In DC plans, the plan defines the contributions that an employer can make, not the benefit that will be received at retirement. The terminating employee receives the proceeds in a current or deferred lump sum or annuity. Since the benefit is not defined, the retirement outcomes are not known in advance.

In 1978, section 401k of the Internal Revenue Code authorized the use of a new type of defined contribution plan that allows for the employee to make pre-tax contributions to the plan.

How It Works

Employee 401k contribution are automatically deducted from their paycheck each pay period. This money is taken out before the employees paycheck is taxed. The contributions are invested at the employees direction into one or more funds provided in the plan. Employers often "match" employee contributions, but are not required to do so. While the investments grow in the employees 401k account, they do not pay any taxes on it.

Advantages and Benefits

401k plans offer many benefits, but there are restrictions also.

  • Any business, whether a C Corporation, S Corporation, partnership, sole proprietorship, self-employed can establish Plan.
  • The company sets the eligibility requirements, within certain guidelines, at the time the plan is established.
  • Employer can restrict individuals with less than one year service, union members, non US citizens, part-time workers, etc., from being eligible for the plan.
  • Contributions to plan can come from voluntary employee salary reduction, from employer, or both.
  • Each individual employee can defer in 2020 $19500
  • Participants age 50 and over can make additional "catch-up" contributions of $6,500 in 2020.
  • Employees are immediately 100% vested with their own salary reduction tax deferred contributions.
  • Employee withdrawals before age 59 1/2 may be subject to 10% penalty.
  • Employees who retire any time during the calendar year in which they turn 55, or later, are not subject to the 10% penalty.
  • Employers can establish a vesting schedule, within certain guidelines, for the contribution the company makes to the 401k.
  • Employers are not required nor obligated to make any contribution to the 401k, although employer may have some obligation to contribute if plan is deemed top heavy.
  • Turnkey and Internet based plans are available.
  • Excellent range of investment options available for the plan sponsor to offer within the plan.
  • The investment choices in most plans range from 8 to 25 options. The average plan has about 19.
  • 401k plans may permit "self-directed investment accounts" and company stock purchase within the plan.
  • Employee contributions to the plan are not subject to federal income taxes until a distribution from the plan is made. Any investment gains and earnings also enjoy tax deferral until distribution.
  • This type of plan can permit loans and hardship withdrawals, but is not required to do so.
  • Participants can start, stop contribution during course of year, as determined by the company.
  • The employer can receive certain tax benefits for contributions.
  • Plans are subject to top heavy and discrimination testing.
  • Typically the amount the owners and highly compensated individuals can contribute to a 401k is a function of the contributions of the other employers.
  • 401k plans can be subject to IRS Form 5500 filings.
  • Generally, the vendor selected by the plan sponsor does all accounting, participant reporting, testing, and files 5500 reports with the IRS.

401k plans have proven to be popular with employees for several reasons. The tax deferral is obviously high on this list of reasons. Others include the increased portability of this plan, employer matching contributions, and the increased control associated with self-direction of investments.

The plan sponsor is required to provide you with a Summary Plan Description. Read it! It contains lots of good information on how your plan works, what options are available, who the trustees are, and other important information. You can always ask for another one if you misplace your copy.

You are the only person who has your own vested interest fully at heart, so it is up to you to ensure you know what your plan is all about and how to take full advantage of it. The only way to do this is to educate yourself. Go to all educational opportunities that your employer offers. Read all the material your employer provides on the plan.