401(k)

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A 401(k) plan is a type of employer-sponsored defined-contribution retirement plan. Its name comes from section 401(k) of the Internal Revenue Code [1] which defines it. It is also generally governed by Title I of the Employee Retirement Income Security Act of 1974 (ERISA). According to the latest (2008) Survey of Income and Program Participation (SIPP), 60 million individuals (33.0% of the U.S workforce) participated in 401(k) plans. In 2008, individuals made average annual contributions of $4,513 to the plans. The nation's 511,582 401(k) plans held $2.23 trillion dollars at year end 2008. [2]

Advantages

  • You get an immediate tax break, because contributions come out of your paycheck before taxes are withheld.
  • Many employers will match your contributions at least partially, e.g., 50 cents on the dollar for the first 6 percent you save. If an employer has "frozen" the company's defined benefit plan, the company may augment the company match in the 401-k plan to compensate for the reduced defined plan benefit.
  • You get tax-deferred growth - meaning you don't pay taxes each year on capital gains, dividends, and other distributions.
  • When eligible to participate, you can normally contribute more to the 401(k) than to your IRA. [3]

Disadvantages

  • Generally not designed to allow access to funds before age 59 1/2 without paying taxes and a 10% penalty.
  • Available funds are chosen by the employer; they may be better (institutional shares) but are more often worse (high-cost funds) than funds available in personal accounts. (You may have greater fund selection if the plan has a Self directed brokerage account.)
  • Employer may change the fund selection at any time.
  • Not insured by the Pension Benefit Guaranty Corporation (PBGC).
  • Employer contributions may not become vested (i.e., become the property of the employee) until a certain number of years have passed.

Employer stock

Some plans offer employer stock as an investment option, and/or contribute the employer match in the form of employer stock. Plans offering employer stock must offer at least three diversified investment options with materially different risk and return characteristics. They must allow diversification of elective deferral contributions immediately (at least quarterly) and allow diversification of employer contributions after three years of service by the employee.

Keeping your 401(k) contributions in employer stock is not recommended, as you already have plenty of risk tied with the performance of your employer, and diversification or complete avoidance is strongly recommended. See, however, Net unrealized appreciation, if you hold employer stock with a low basis and you are considering a lump sum distribution rollover of plan assets.

Automatic enrollment and contributions

Employers may configure their plans to automatically enroll eligible employees, unless that employee opts out. Automatic enrollment contributions can normally be withdrawn penalty free, if requested within 90 days of the first deferral and completed within 6 months of the plan year in which they began. A safe harbor for nondiscrimination testing is available if plans have:

  1. Initial deferrals of at least 3% of pay, increasing annually by 1% to a number between 6% and 10% of pay,
  2. Either
    1. An employer match of 100% on the first 1% and 50% on the next 5% of pay, or
    2. A 3% nonelective contribution,
  3. 100% vesting after two years,
  4. Default investment selections satisfying Department of Labor regulations, and
  5. Annual notice to all employees regarding their right to opt out or change the automatic provisions.

Provided the notice requirement is met, and the default investments satisfy Department of Labor regulations, automatic enrollment will be governed by ERISA and preempt any contradictory state laws. [4]

Target retirement funds

The default option for employer provider plans is to place your contributions and employer matches into a target date retirement fund.

Empirically, investor allocation to target retirement funds has been increasing. Vanguard reports data for the employer provided funds it manages in annual 'How America Saves" studies. Among the findings:[5]

  • Employee account balance holdings of target retirement funds has increased from a 3% allocation in 2006 to a 17% allocation in 2012.
  • Employee contributions to target retirement funds has increased from 4% in 2006 to 31% allocation in 2012.
  • In 2012, employees 25 years old and younger held 68% of their account balances in target retirement funds.
  • In 2012, employees with less than 10,000 dollars in their plans held 56% of their account balances in target retirement funds.

Nonelective contributions

Employers can make certain other contributions not elected by the employees, such as profit sharing contributions. Before 2007, these contributions had to become vested on or faster than either a) 20% each year from years 3-7 of service or b) 100% after 5 years of service. Contributions made in and since 2007 must become vested on or faster than either a) 20% each year from years 2-6 of service or b) 100% after 3 years of service (with an delayed effective date for collectively bargained plans).

Nondiscrimination

Under ERISA, retirement plans including 401(k) plans are not allowed to discriminate in favor of highly compensated employees. Corrections can be made by returning the excess contributions to those highly compensated employees within a specified period of time after the plan year ends. The returned funds are taxable income when received. The time period varies based on other features of the plan, generally from 2.5 to 6 months. If not returned timely by the employer, the employee will also be subject to an additional 10% excise tax.

This rule is waived for plans which meet certain safe harbors.

Early withdrawals and loans

  • Hardship withdrawals, which may include withdrawals after the onset of sudden disability, money for the purchase of a first home, money for payment of higher education expenses, money for payments necessary to prevent eviction or foreclosure, and money for certain medical expenses that aren't reimbursed by your insurer. This includes hardships of your beneficiary under the plan. Conditions which determine a hardship are defined in the 401(k) plan.[6]
  • Qualified reservist distributions may be made to military reservists called up for at least 180 days, with no early withdrawal penalty. Reservists may re-contribute the amount of the qualified reservist distribution to an IRA in the 2 year period beginning the day after the end of his or her active duty.
  • Most major companies also offer a loan provision on their 401(k) plans that allow you to borrow against your account and repay yourself with interest. Restrictions will vary by company but most let you withdraw no more than 50 percent of your vested account value as a loan. You then repay the loan with interest, through deductions taken directly from your paychecks. The loan must be repaid within 5 years unless it is used to buy your main home.[7]
  • Most distributions (both periodic payments and lump-sum payments) from qualified retirement plans, including 401(k)'s, made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income. The additional tax does not apply if:
  • The distribution is made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy.
  • The distribution is made because you are totally and permanently disabled.
  • The distribution is made after the death of the original 401(k) owner.

However, distributions from your workplace savings plan are not subject to the 10% early withdrawal penalty if you are age 55 or over when you separate from service with your employer.

Rollovers

When you change jobs, you can leave your 401(k) money where it is, move it to your new 401(k), or move it into an IRA, which is called a rollover. Should you die, your designated beneficiaries also may rollover their inherited balance to an IRA, which will be treated as an inherited IRA. However, after leaving the employer if your vested balance is below $5,000 then the employer may distribute the account either to you or a rollover IRA account in your name, provided adequate notice is given. This rule about balances below $5,000 applies at all times, not just at the time you leave the employer.

If you change jobs and decide to leave your 401(k) with a former employer, there may be unforeseen circumstances which will result in difficulties obtaining your funds at a later time. For example, the company may go out of business, be resold, or not keep adequate records. While you are legally entitled to your funds, the practicality of these unplanned situations can result significant delays or nonpayment. For these reasons, it is strongly recommended to not leave your 401(k) money with a former employer.[8]

Required Minimum Distributions

An account owner must begin making distributions from the accounts at least no later than the year after the year the account owner turns 70½ unless the account owner is still employed at the company sponsoring the 401(k) plan. The amount of the distribution is based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. A penalty is applied to anyone failing to make the minimum distribution. The penalty is 50% of the amount that should have been distributed.

Roth 401(k)

An employer may also elect to make Roth 401(k) contributions available. They are the 401(k) equivalent of Roth IRA contributions, and if the 401(k) is rolled over they can be rolled directly to a Roth IRA or another Roth 401(k). These are normally administered as a sub-account of the employee's 401(k) account. Both Roth and regular contributions are subject to the same contribution limit. Whether an employee is contributing regular or Roth 401(k) funds may not influence the employer match, which must be made to the regular contribution sub-account. [9].

After-tax 401(k)

An employer may also elect to make after-tax 401 (k) contributions available. These are the 401(k) equivalent of non-deductible traditional IRA contributions, and if the 401(k) is rolled over they can be rolled directly to a Roth IRA. These are normally administered as a sub-account of the employee's 401(k) account. The limit to after-tax contributions is significantly higher than the elective deferrals limit. IRC Section 415(c)(1)(A) sets the total contribution limit for both employee and employer contributions to a 401(k), and is summarized in Overall limit on contributions. Therefore, the after-tax contribution limit for an individual is the remaining amount allowed after all employee and employer contributions. And for most individuals that can afford to contribute, it would allow them to save nearly twice as much money in tax-advantaged space as the combination of elective deferrals and employer contributions.

Just like non-deductible traditional IRA contributions, earnings are taxed upon withdraw or conversion. Therefore, to minimize the tax on gains, it is preferable to make after-tax contributions in a plan that also allows regular in-service distributions. If the after-tax contributions are rolled directly to a Roth IRA immediately (or regularly), the gains -and taxes- will be minimal.

Although 401(k) plans that allow both after-tax contributions and in-service distributions of those contributions are rare, there is the potential to greatly increase yearly contributions to a Roth IRA indirectly -well beyond the yearly Roth IRA contribution limits.

Expensive or mediocre choices

Even in a bad 401(k), you should contribute up to the company match. Choose the lowest-cost funds; many bad 401(k)'s have a few lower-cost funds. If you are eligible, additional contributions should usually go into a Roth or Traditional IRA. But unless your 401(k) is very bad and you expect to stay a very long time with the same employer, investing unmatched money in the 401(k) is likely to be better than taxable investing, because you can roll over your 401(k) to a low-cost IRA when you leave.

A reasonable rule of thumb is to consider investing in a taxable account if the product of the extra costs and the number of years you will stay in the plan exceeds 30%. That is, if you pay 1.70% expenses rather than 0.20%, you should still invest in the plan unless you are reasonably certain that you will stay with the employer for more than 20 years. The reason is that a long-term investment, even in a tax-efficient stock fund, is likely to lose 30% or more of its value to taxes on the dividends and capital-gains tax when you sell.[10]

Now, before you consider forgoing your 401(k), you may want to talk to the human resources department to see if they can improve the 401(k) plan. You may want to suggest a low-cost plan like Employee Fiduciary[11]. You can find a sample letter to the human resources department at 401k links and suggestions. Keep in mind that the employer likely cares more about the cost of running the 401(k) plan than the expense ratios that the employees have to live with. For this reason, it is not a good idea to stress the problem with the expense ratios too much. (See How to campaign for a better 401(k) plan for more details, as well as Alternatives to a High Cost 401k Or 403b Plan for more guidance).

Involuntary cash out distributions

A defined contribution plan may involuntarily cash out, also described as force out, the accounts of ex-employee participants with a balance of $5,000 or less.[12]

If the balances is between $1,000 and $5,000, then the employer must notify the participant and must provide for the automatic rollover to an IRA or annuity, unless the participant chooses otherwise. Balances of less than $1,000 may be distributed as cash/check to the participant; this will result in an early withdrawal penalty and a taxable event.

A 401(k) plan is not required to make these distributions, but they may, and many plans do so to reduce administrative costs of running the plans. Therefore, people with 401(k) balances of $5,000 or less with former employers should know the rules of their former plan(s) so they may manage their accounts successfully. People with balances of $1,000 or less must take extra care to monitor their account to ensure they don't have their accounts cashed out.

The best way to ensure a small-balance account is handled according to your investment goals is to roll the balance over to an IRA or to a new defined contribution plan (if applicable and if the plan accepts rollovers).

Employer administration

Investment policy statements

Employers are expected to have investment policy statements for the plan, governing the process by which investment selections are chosen and monitored on an ongoing basis.

Timing of contributions

Contributions deferred from an employee's pay must be contributed to the 401(k) plan and allocated to your account "as of the earliest date" the deferrals can be segregated from the employer's assets. According to Department of Labor regulation 2510.3-102, the "earliest date" is the earlier of 1) the first date reasonably practicable on an ongoing basis based on the routine processing of the payroll information, transmittal of data to the plan provider and processing by the provider or 2) the 15th business day of the month following the month in which the contribution was withheld from the employee's pay. Employers are violating ERISA and subject to 15% tax on the deemed interest when failing to contribute timely.

Plan financial reports

Plan financial reports are filed on form 5500, 5500-C or 5500-R. Some of the information from these reports must be made available to employees, often on the company intranet.[13]

See also

References

  1. section 401(k) of the Internal Revenue Code
  2. EBRI Notes, October, 2011, Vol. 32, No. 10.
  3. 401(k) Resource Guide - Plan Participants - Limitation on Elective Deferrals
  4. See Automatic enrollment: Benefits and costs of adoption
  5. How America Saves 2013, Vanguard Institutional
  6. Retirement Plans FAQs regarding Hardship Distributions, from the IRS.
  7. 401(k) Resource Guide - Plan Participants - General Distribution Rules, from the IRS
  8. 401k Vesting Dispute - Need Advice, forum discussion
  9. See Roth 401(k) Investing Guide
  10. See Alternatives to a High Cost 401k Or 403b Plan at TheFinanceBuff.com for more detail.
  11. Employee Fiduciary
  12. IRS Pub 560
  13. See Regulatory Brief: Update on Plan Fee Disclosure for recent regulatory actions

External links

Bibliography

White pages
Academic papers