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What is a 401(k)?
Most large employers now offer their employees a 401(k) retirement plan, sometimes called a "salary-reduction" plan. Typically, the employer sets up the plan with an investment company, an insurance company or a bank trust department. You, the employee, agree to put part of your salary into a special savings and investment account. Most 401(k) plans offer a variety of investment vehicles, from individual stocks or mutual funds to money market accounts. Importantly, the money you invest isn’t counted as income when you complete your annual tax return. For example, if you earn $35,000 but put $5,000 into a 401(k), your taxable income for the year would be only $30,000. Earnings that accumulate in the account are not taxed until you start making withdrawals, usually after you reach age 59 1/2. If you withdraw earlier, you’ll have to pay taxes on the money and a stiff 10 percent penalty. Most companies that offer 401(k) plans also match employee contributions. For example, the company might add 50 cents to the account for every dollar contributed by the employee. That makes a 401(k) plan a much better vehicle for retirement savings than an individual retirement account, which does not involve a matching contribution from your employer.
How did 401(k)s get their name?
The popular 401(k) retirement plan draws its dull name from the Section 401 of the Internal Revenue Code, which also created such exciting programs as the 403(b) from Section 403 and the 457 plan from (you guessed it) Section 457.
How is a 401(k) different from a regular pension?
The biggest difference between a 401(k) and a "regular pension" is that a 401(k) gives you much more control over your retirement nest egg. A 401(k) is funded with your own money and, in some cases, by a contribution from your employer as well. You decide how much to save and how to invest. A traditional, "regular" pension is funded and controlled by your employer.There are two types of pension plans: defined contribution (where the employer contributes a percentage of compensation determined by the formula in the plan document)and defined benefit. A "defined benefit plan" promises to pay you a specific monthly income in retirement -- in other words, a defined benefit. What you get when you retire will be based on your salary and the number of years you worked for the company. The company must put aside enough money each year to fulfill this promise but occasionally -- as some workers have unfortunately discovered -- it’s a promise that the employer may not be able to keep. Sometimes employers go bankrupt.
Most pension plans are covered by the Pension Benefit Guarantee Corp., which guarantees benefits to workers even if a firm is liquidated in bankruptcy. There are some plans that are not covered, however, such as those offered by professional service firms (such as doctors and lawyers) with fewer than 26 employees, by church groups or by federal, state or local governments.
How is a 401(k) different from a profit-sharing plan?
Technically, 401(k) plans are considered profit-sharing plans. But on a practical level, they’re usually different in several ways from the classic profit-sharing plan. In a profit-sharing plan, the employer makes contributions for eligible employees whether or not they also contribute to the plan. However, In a 401(k) plan eligible employees can choose to participate or not. If they choose to participate, they make their contributions pre-tax through a salary deferral agreement with the employer. Their deferral may or may not be matched by the employer. Since it is a type of profit sharing plan the employer can also make profit sharing contributions to the plan. These contributions (also called non-elective contributions) are allocated to all eligible employees whether they contribute to the plan through deferrals or not.
How long do I have to wait after being hired to join the 401(k) plan?
Some companies allow workers to join their 401(k) plans immediately. But other companies utilize a federal law that allows firm to wait until a worker has logged at least one year of service before joining the plan. The reason: Many employees quit before their first year is up, and companies want to avoid the administrative costs involved in setting up a 401(k) for a worker who might not stay very long. A company is also allowed to exclude anyone under the age of 21. In part, that’s because younger employees often don’t take advantage of the plans even when they are eligible (even though they should). If younger workers are eligible to join the plan but don’t, their lower participation rate can reduce the amount that other employees are permitted to contribute because of federal rules.
What happens to the money I put into the 401(k) plan?
The money you put into a 401(k) plan is invested according to the choices you’ve made from a list of options offered by your employer. These options typically include stock and bond mutual funds, money market funds, a guaranteed investment contract (GIC) that pays a fixed interest rate and your company’s stock.
What information about my 401(k) plan am I legally entitled to have?
The federal government requires companies to provide only minimal information to workers who take part in a 401(k) plan. Technically, all you’re entitled to is a summary of how the plan works, a summary annual report and an annual statement. If the plan allows you to invest in the company’s stock, you are also entitled to receive a prospectus or similar document. Fortunately, many companies provide far more, and you can also do your own research. For example, if a mutual fund is offered in your 401(k), you’re free to contact the fund directly and ask for its performance history and other pertinent information. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), federal disclosure requirements are so minimal "because 401(k) plans are governed by a law that was written before they existed-the 1974 Employee Retirement Income Security Act, better known as ERISA. ERISA didn’t anticipate pension plans in which employees would make most of the investment decisions; consequently, its disclosure rules are relatively undemanding. But don’t worry, you probably won’t have any difficulty getting much more information than ERISA requires. Employers are strongly motivated to provide employees with all the information they need to use the plan wisely."
What recourse do I have if my employer and I disagree about my 401(k) account?
Most questions or problems concerning a 401(k) can be cleared up quickly and amicably with a phone call or a letter. But major disagreements must usually be solved through a more formal process. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Your employer is required by law to include a claims review process in which you can file a written claim with the plan administrator. That’s the person or committee responsible for handling the day-to-day administration of the plan. The plan administrator must respond to participant questions and give an explanation for any denial of benefits. If you don’t find the explanation acceptable, you can request a review of the matter. If you’re still not satisfied, you should seek outside support from an attorney and/or the Department of Labor."
How do I know how well my 401(k) investments are doing?
If you have invested in a 401(k) retirement plan, it’s important to stay abreast of how your investment is faring. At a minimum, the company that administers your plan will provide an annual statement that shows the amounts you have contributed and how those investments have performed. Many plans report on a semi-annual or quarterly basis, and some even issue monthly updates. Of course, you can probably get a pretty good handle on how your 401(k) retirement portfolio is doing on a daily or weekly basis by checking the business section of your local newspaper or by reading publications such as The Wall Street Journal or Barron’s. If the bulk of your portfolio is in mutual funds or your company’s stock, for instance, those publications can tell you how much their value has changed over the course of a given day or week.
Do employers guarantee 401(k) accounts?
Employers never guarantee 401(k) accounts. They are instead considered "fiduciaries" of 401(k) plans, which means they are legally responsible for supervising-not guaranteeing-the money you invest. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), this supervisory relationship obligates the employer "to protect your financial interests by choosing reputable and competent plan trustees, administrators and investment managers and continuously monitoring their performance of their duties. If employers choose to follow the voluntary 404(c) regulations established by the Department of Labor, they must give plan participants at least three distinctly different investment choices, each of which has a different level of risk. You must also be given the opportunity to move your money among these investments at least quarterly, and sufficient information to make sensible, informed investment decisions. But your employer doesn’t offer you protection against any investment losses you may suffer."
Does the government guarantee my 401(k) account?
Although most traditional pension plans are insured by the federal government, there is no such guarantee for 401(k) accounts. Traditional pension plans are insured by the federal Pension Benefit Guaranty Corp. because the government wants to ensure that the payments a company promises its retirees will indeed be made. But 401(k)s do not involve a promise of future benefits. The value of your account will rise and fall over the course of the years, and you could theoretically be wiped out if your investments perform badly. If it helps you sleep better, you may want to know that one of the duties of the federal Pension and Welfare Benefits Administration is to ensure that all employers and 401(k) trustees follow government requirements. That’s not as good as a guarantee, but it’s better than nothing.
What happens to my 401(k) account when I retire?
If you have a 401(k) and retire, you will likely have four choices(assuming you are over 59 1/2). According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), those choices will be: 1. Taking the money in a lump sum. If you do, you’ll owe income taxes on all of it. The disadvantage is that after you’ve taken the lump-sum distribution, your money is no longer in a tax-deferred retirement account. That means that the only way to avoid tax on any future earnings is to invest it in tax-exempt instruments. 2. Rolling your entire balance into an IRA. Then you can take out money as you need it, paying income taxes only on the amount you withdraw. This gives you more flexibility than any other option. Most of your money will continue to be sheltered in a tax-deferred account. You’ll have a nearly unlimited choice of investments, too. 3. Taking a 401(k) payout as a lifetime annuity. Not all plans offer this. An annuity pays a monthly benefit for your lifetime alone or, if you choose a joint-and-survivor annuity, for your lifetime and your spouse’s. The advantage of an annuity is that it provides a guaranteed lifetime benefit. The disadvantage is that, because it’s a fixed amount, its purchasing power will be reduced every year by inflation. 4. Leaving some or all of the money in your 401(k). You must have at least $5,000 in your account to do this. This choice makes little sense, however, since, if you like the investments available in the plan, you can use those same investments in your own IRA and completely control you access to your money. If you leave it with the plan, you’ll need to comply with the plan administrator’s rules and proceedures for making withdrawals or changing investments.
What happens to my 401(k) account when I die?
One of the first things you are supposed to do when you join a 401(k) is to designate a beneficiary who will receive the money in your account when you die. If you somehow failed to designate a beneficiary, your estate will automatically become the beneficiary. If your beneficiary is your spouse, he or she will have most of the same options with the money that you would have if you were leaving the company to take another job. Your spouse could roll the money over into an Individual Retirement Account (IRA), or withdraw it all and pay income taxes on it. If your spouse decides to roll the money over into an IRA, the rollover should be direct from the employer to the IRA account. This prevents deduction of any withholding tax. If your survivor decides to withdraw the cash and pay the taxes, the Internal Revenue Service will waive its early withdrawal penalty regardless of the spouse’s age. Importantly, though, your spouse will probably not have the right to keep the money invested in the same 401(k) plan. Even more restrictions would be placed on your beneficiary if the beneficiary is not your spouse. For example, the beneficiary couldn’t roll the money over into an IRA. Most plans provide for full vesting when you die, so any matching contributions made by your employer would likely be included in the distribution to your beneficiary.
What happens to my 401(k) account if I’m disabled?
If you are completely disabled and cannot work, you can tap your 401(k) plan without being charged a 10 percent penalty regardless of your age. However, you will owe ordinary income taxes on the money you withdraw. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you’re disabled, you may also be able to take out any matching contributions your employer made even if you haven’t completed the years of service normally required for vesting. Most plans provide for full vesting whenever a participant becomes disabled. But each plan has its own definition of what’s required to qualify for disability. Ask your human resources or personnel department about your plan’s rules. "If your plan does provide full vesting for disabled employees and your employment is terminated as a result of a qualifying disability, you’ll receive your vested account balance-your contributions and your employer’s contributions and what they earned. If your plan doesn’t have a disability feature, or if you don’t meet the plan’s definition of disability, your distributions from the plan will be processed the same as those of other former employees."
Does participating in a 401(k) affect any of my other benefits?
Participating in a 401(k) plan probably won’t affect any of the other benefits your employer offers, as long as you make sure the amount you contribute is added back to your salary for the purpose of calculating those other benefits. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you earn $40,000 a year, for example, and contribute $2,000 to the 401(k) plan, your taxable income is reduced to $38,000. That means that if your group life insurance covers you for twice your salary, you’ll have only $76,000 of coverage-unless the 401(k) contribution is included in the calculation. Talk to your human resources or personnel department about it."
Why are the dividends on the employee stock portion of my 401(k) plan paid out to me instead of being reinvested?
Corporations often pay out the dividends on the employee stock portion of their 401(k) plans because doing so can provide the companies with an important tax break. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Under the Internal Revenue Code, dividends paid on employer stock held in a 401(k) plan are fully deductible to the corporation if paid directly to the employee and are fully taxable to the employee. Therefore, the corporation may want to take this option to get a current year tax deduction."
How can having a 401(k) help my child qualify for financial aid?
One commonly overlooked benefit of making the maximum annual contribution to a 401(k) retirement plan is that it can boost your child’s chances of getting financial aid when it’s time to go off to college. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Increasing your 401(k) contributions to the maximum level might make it easier to qualify for financial aid because these balances are excluded from most college-aid calculations and reduce your taxable income at the same time. Earnings within such plans accumulate on a tax-deferred basis and may be borrowed under certain exacting standards for your children’s education. Interest that you pay back to your account is not tax-deductible, but does accrue to your account balance. You should make sure your plan allows borrowing if you consider this alternative." Before you take this approach you should check out your plan’s loan rules. Some plans don’t allow loans, and some plans have very restrictive provisions that may invalidate this idea.
If I’m saving money that I plan to use before I retire, does it make sense to do it with after-tax 401(k) contributions?
If you’re saving money that you plan to use before you retire, it’s usually better to save it outside your 401(k) plan. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "It’s true that usually you can withdraw your after-tax 401(k) contributions at any time without taxes or penalty, but remember, you’ll owe taxes on any interest they earned, as well as a 10% early withdrawal penalty if you’re under age 59 1/2. The 10% penalty is an expense you wouldn’t have if you saved on an after-tax basis outside your 401(k) plan. "But there are situations where it can make sense to use after-tax contributions for short-term savings: if your employer matches your after-tax contributions and if you’re fully vested in the matching contributions by the time you withdraw the money, you may wind up with more money by saving in the 401(k) plan, even after taking the 10% early withdrawal penalty into account."
Are the assets in my 401(k) plan exempt from creditors in a bankruptcy?
The U.S. Supreme Court has held that savings in a qualified retirement plan, such as a 401(k) or IRA, are exempt from creditor claims in a bankruptcy. However, some courts have allowed the IRS to invade plan assets to recoup amounts owed by the plan participant. In fact, ERISA (the comprehensive pension law enacted in 1974) does not protect plan assets from IRS claims against a participant’s qualified plan or IRA account.
