401(k)

Introduction
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 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 Survey of Income and Program Participation (SIPP), 401-k plans had the following levels of participation in 2005, the latest year of the survey:

[Source: EBRI Notes, May 2008, Vol.29, No. 5]

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.

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

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.
 * 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.
 * 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.

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.

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. (See Roth 401(k) Investing Guide).

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. (See Regulatory Brief: Update on Plan Fee Disclosure for recent regulatory actions]

Links

 * IRS IRC 401(k) Plans
 * 401khelpcenter.com
 * The Hewitt 401(k) Index™ Observations
 * 401(k) Plans For Small Businesses
 * History of 401(k) Plans
 * IRS Publication 575 (2007), Pension and Annuity Income
 * 401-k Links and Suggestions (forum post)

Fund Company Research Institute Links

 * The Expanding "Roth" Retirement Account TIAA CREF Institute by Alicia Waltenberger, Douglas Rothermich, and William Reichenstein (March 2006)
 * Tax diversification and the Roth 401(k) by Vanguard Center For Retirement Research (October 2005)
 * Employer and employee attitudes toward company stock in 401(k) plans Vanguard Center for Retirement Research (10/20/2003)
 * The role of company stock in defined contribution plans Vanguard Center for Retirement Research (08/01/2002)
 * 401(k) design: Match, loan, and investment menu effects The Vanguard Center for Retirement Research (01/10/2006)
 * Measuring the effectiveness of automatic enrollment Vanguard Center for Retirement Research (01/09/2008)
 * Immediate income annuities in defined contribution plans Vanguard Center for Retirement Research (06/06/2008)

Academic Links

 * Bodie, Zvi and Treussard, Jonathan, "Making Investment Choices as Simple as Possible: An Analysis of Target Date Retirement Funds" (January 21, 2007). Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=900005
 * Elton, Edwin J., Gruber, Martin J. and Blake, Christopher R., "The Adequacy of Investment Choices Offered By 401K Plans" (March 15, 2004). EFA 2004 Maastricht Meetings Paper No. 1176 Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=567122   or DOI: 10.2139/ssrn.567122
 * Forman, Jonathan Barry, "The Future of 401(K) Plan Fees" . New York University Review of Employee Benefits and Compensation, pp. 9-18, 2007 Available at SSRN: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1092156
 * Hamilton, Brooks, Author's page available at http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=920853
 * Hutcheson, Matthew D., "Uncovering and Understanding Hidden Fees in Qualified Retirement Plans-3rd Edition," The Elderly Law Journal, (Fall, 2007). Available at http://www.401khelpcenter.com/pdf/mdh_understanding_fees_v4.pdf