The 401(k) takes its name from subsection 401(k) of the Internal Revenue Code. It cropped up in the 1980s as an appendage to pensions. A 401(k) is a retirement savings plan and is sponsored by an employer. Earlier, the employers used to offer pension funds.
A 401(K) plan is offered by employers to eligible employees as a retirement plan. A part of the salary is deducted at source to towards the 401(K) account to which the employer contributes the same or a non-elective amount. The employers can also make profit-sharing features as part of the deal. It can be a post or pre-tax basis contribution. Understanding the 401(K) plan will help you realize its various benefits and to create a postretirement plan.
Here is a quick overview of the 401(K) plan:
How it Works
The workers can save and invest a part of their paycheque before giving the taxes. Taxes need not to be paid before the withdrawal of the money from the account. This means that you can save money towards your retirement saving plan without paying income taxes on your savings or on your investment earnings. This is before you withdraw the money at the time of retirement. The amount you receive at the time of withdrawal will be the post-tax deducted amount. You can control how you invest your money.
The Rules of Withdrawal
401(K) is an effective saving plan. But, it has a number of limitations and admonitions. Generally, you can’t tap into your employer’s inputs immediately. There are stiff rules when you can withdraw the money and there are penalties for the withdrawal of the money before the retirement age.
Now you must be thinking how this plan is going to work for you. Before the taxes are withdrawn the money is deducted from your salary, hence your taxable income is lowered and consequently, this lowers your taxes for some services like the administrative, investment management. Sometimes the outside consulting services charge fees which can be charged either to the employer, or the participants of the plan or to the plan itself.
Type of 401(K) Plan
There are many types of 401(k) plans:
- Traditional 401(k) plans
- Safe harbor 401(k) plans
- SIMPLE 401(k) plans
- Solo 401(k) plans
- Roth 401(k) plans
You can combine the saving plans together for greater benefits. For example, you can have traditional 401(K) plan along with the Roth 401(K) plan, but you cannot combine the SIMPLE 401(k) plans with others. You can be enrolled in a 401(k) plan by most of the companies right away. However, you might have to wait in some cases. In such cases, you can start your own individual retirement account and then lodge a complaint with the HR office. If your company is unstable or it goes under then the plan is likely to be terminated. In such cases, you can transfer the money to a traditional IRA to avoid paying the income taxes and 10% withdrawal penalty. Under the ‘force out’ provision, the former employees can close their 401(k) accounts if their account balances are low.
When you leave the Company
Many people would like to know what happens to their 401(K) plan when you leave the company. There are other provisions to continue your retirement plan without disturbing the current one. If you leave your employer, then you can do the following with your 401(k) account balance:
- Roll over the balance in your account into your new employer’s plan.
- Roll over the balance into an IRA.
- You may leave your balance in its plan if allowed by your former employer
- Withdraw your account
Employees can contribute the funds on a post-tax elective deferral basis, with an addition to, pre-tax elective deferrals under their traditional 401(k) plan. An employee cannot exceed the IRS limits for deferral of the traditional 401(k). Matching funds of the employer are not included in the elective deferral cap, though they are considered for the maximum section 415 limit of $51,000 for 2013.
Why 401(K) is popular
The 401(K) has grown in popularity and employees are actively participating in it. One of the important reasons why it has grown in popularity is the various investment plans and decreasing expenses of fund management. Another reason is its hassle-free enrolment. Most of the company automatically put employees on the 401(K) retirement plan. The great flexibility is another reason for its growing popularity. Additionally, the contribution limits are subject to inflation, which allows the contributors to increase the investment over time.
The Bottom-Line
401(K) retirement plan is one of the best options for people looking for easy and cost-effective saving plans. Knowing the plan in detail will help you make informed decisions on choosing the right retirement plan for you. Stay safe and financially secured with the right 401(K) plan.