Many employers that offer retirement benefits do so through a 401(k) deferred compensation plan (the name comes from the number of an IRS regulation that provides the plan with its tax-deferred status). 401(k) plans are deferred compensation programs in which employees invest part of their wages, sometimes with added employer contributions, to save on taxes; they are not actually pension programs that establish a right to retirement benefits. This article explains the basics of 401(k) plans.
In a 401(k) plan, an employee contributes part of his or her salary to one of several retirement investment accounts set up by the employer and administered by a bank, brokerage, or other financial institution. Depending on the rules of the particular plan, the employer often makes a contribution in addition to the amount the employee sets aside. However, unlike traditional pension plans, the employer has no obligation to contribute anything and can change the contribution amounts from year to year.
These plans are cheaper for the employer than more traditional pension plans, because employees make the primary contributions from their salaries, the employer has no fixed obligation to contribute, and, when the employer does contribute, it does so as a tax-deductible business expense.
401(k) plans do not require either the employee or the employer to contribute any set amount each year. The IRS limits how much an employee can contribute each year. The maximum permissible contribution amount goes up each year with the rise in the cost of living. There is no legal limit on the amount an employer may contribute, but most employers contribute a percentage of the amount of the employee’s contribution.
A 401(k) plan usually offers the employee a choice among different investments for the deferred income. Some plans offer a selection of preapproved savings accounts, money market funds, stocks and bonds, and mutual funds. Other plans permit employees to select their own investment funds or even to buy individual stock shares on the open market. However, there are usually some limits on the number of investments offered and on the frequency and number of changes in investments that can be made in a given period of time.
Tax Advantages of 401(k) Plans
A 401(k) plan has two tax advantages for the employee.
First, income taxes on the amount of wages invested in the plan are not paid in the year you earn them but are deferred until you withdraw the money from the plan after retirement. Most people have significantly lower income tax brackets after they stop working, so the total tax paid on the income is lower.
Second, taxes on income earned by the investments of the 401(k) plan are likewise deferred until the money is withdrawn after retirement.
401(k) investments may be risky. Along with a choice of investments for the employee comes the risk of poor returns. Unlike traditional pension plans that sink or swim on the total pension fund’s portfolio and are backed up by the government’s Pension Benefit Guaranty Corporation, the amount of an employee’s 401(k) plan fund at retirement depends entirely on how well the plan’s individual investments do over the years. An employee who makes particularly risky investments could wind up with less in 401(k) funds than he or she invested.
One of the advantages of most 401(k) plans is that they permit you to withdraw your deferred compensation earlier than pension plans. Most 401(k) plans permit withdrawal without any tax penalty at age 59½, or at age 55 if you have stopped working. Funds may be withdrawn in a lump sum or in monthly allotments. Money that remains in the account, including future earnings, will not be taxed until withdrawal. 401(k) plans also allow your beneficiaries to withdraw the 401(k) funds without tax penalty if you die at any age.
If you withdraw funds before the age permitted by the rules of your plan, you will pay a 10% penalty on the amount withdrawn, plus all income taxes at your current tax rate. And IRS rules require that you begin withdrawing funds by age 70½ at the latest. The amount you must withdraw to avoid a tax penalty is determined by the IRS based on your age and the year you were born. The administrator of your plan can tell you your minimum withdrawal amount.
Some 401(k) plans also permit you to withdraw funds without penalty if needed for a family emergency, such as for medical expenses or for investment in a home. And, in some plans, you can take out a loan from your own 401(k) funds, up to 50% of the total in the account or $50,000, whichever is less, if you have sufficient collateral and you repay it within five years. There are strict rules applying to such withdrawals and loans. Check with your 401(k) plan administrator or a financial adviser.
For an explanation of how to take money out of your retirement plan, see IRAs, 401(k)s, & Other Retirement Plans: Taking Your Money Out, by Twila Slesnick and John C. Suttle (Nolo).