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Basics of a 401(k) retirement plan

The 401(k) retirement plan was first introduced in the year 1978. It is currently one of the most popular plans among the employer-sponsored retirement plans, depended on by millions of employees in America. Employers use the 401(k) plans to distribute company stock to the employees. Few plans can equal the flexibility offered by this plan.

A 401(k) retirement plan is one that gives an employee the choice between being compensated in cash or deferring a part of the cash towards a retirement account, the 401(k) account. The cash deferred by the employee, should he defer it, is not taxable unless he chooses to withdraw it. The employee also has the choice to make post-tax contributions to the 401(k) account, otherwise called the Roth 401(k)s. Naturally, when these are withdrawn, they would be tax free. The 401(k) retirement plans are also called qualified plans signifying that these plans are governed by a set of regulations. These are stipulated in the Employee Retirement Income Security Act of 1974 and, understandably, the tax code.

Qualified plans can be either a defined contribution or defined benefit pension plans. 401(k) plans are defined contribution plans where the account holder’s balance is determined by his contribution to the plan and the manner in which the plan has performed given the market conditions. As opposed to a pension plan, the employer does not have to make any contributions toward the 401(k) retirement plan. However, some employers choose to match whatever the employee contributes by a contribution of their own toward the employee’s retirement fund under a feature that is profit sharing in nature. A profit sharing plan is any retirement plan that receives contributions made by employees at their discretion. This profit sharing feature is also called deferred profit sharing plan or DPSP. It gives employees a share in the company. Employees receive this share as a percentage of the profit made by the company on the basis of the company’s earnings, either quarterly or annually. It is an excellent way to give employees a sense of ownership even though it comes with limitations on when and how an employee can withdraw this amount.

As of 2017, an employee can defer a maximum of $18,000 to his/her 401(k) retirement plan. If an employee is 50 or older by the end of the year, he/she can make a catch-up contribution of $6,000, a provision created by the Economic Growth and Tax Relief Reconciliation Act of 2001 in order to enable the elderly to save up enough for their retirement. The catch-up contribution was supposed to end by 2011, but the Pension Protection Act of 2006 made this a permanent one. Although this is an excellent way to increase savings, a study found that only 13% of those eligible for this actually did make use of it. The maximum contribution allowed jointly by employer and employee for 2017 is $54,000, and in case of employers 50 years or older, it is $59,000. An employer can contribute through three ways: matching contributions, non-elective contributions, and profit-sharing contributions.

Generally, the contributions made in the 401(k) are invested in mutual fund portfolios, stocks, bonds, certificates of deposit, annuities, collectibles, and exchange-traded funds, as permitted by the governing plan provisions. Most 401(k) retirement plans come with an option to invest inexpensively in assets that are diversified through the vehicle of index funds. Index funds include the addition of both stocks and bonds. Some 401(k) retirement plans allow for the addition of real estate options in the form of REITs. A real estate investment trust is a security that invests in real estate and is considered to perform well over time in the various properties or mortgages it is involved in, with diversification.

While the money in a 401(k) account grows tax deferred, withdrawing the money comes with a set of limitations. One can withdraw funds from the 401(k) retirement plan only in case of an employee’s retirement, death, disability, or if his employment with the said employer is done with. The money can also be withdrawn once the employee is 59 and a half years old, if the plan is terminated or if he experiences a hardship according to what the plan defines hardship as, such as having to pay medical bills. At the age of 70 and a half, a required minimum distribution must begin for an employee. If distributions occur before an employee is 59 and a half years old, they will be counted ordinary distributions and have a 10% penalty on them. There are exceptions to this case in the event the employee dies, gets disabled, is no longer employed at that particular job after he is 55 years old, or if the employee has medical bills that are 10% and above his gross income, or if the amount is not taxable. Therefore, carefully check the 401(k) retirement plan before committing.

It is predicted that 401(k) retirement plans will play a significant role in the planning of retirement in millions of employees in the years to come.

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