A 401(k) is an employer-sponsored retirement savings plan. The plans allow employees to save money for retirement on a tax-deferred basis, which means federal or state taxes aren't paid on the earnings until the money is withdrawn. Employees enrolled in 401(k) plans have money deducted from their paycheck and deposited directly into their 401(k) account each month.
Since the money is taken out before taxes, employees end up paying less in taxes because they have don't have as much taxable income. The Internal Revenue Service, however, set limits on how much employees can contribute to a 401(k) plan each year. For 2013, employees are limited to putting $17,500 into their 401(k) account — up from $17,000 in 2012 and $16,500 in 2011.
Eligibility to participate in 401(k) plans is different at each company. While some businesses allow employees to start contributing to a plan as soon as they are hired, others require a waiting period of one month to one year. Often, employers entice employees to participate in 401(k) plans by offering contributions of their own. Under 401(k) plans, employers have the option of matching contributions made by the employee. The amount differs, but the majority offer to match between 25 percent and 100 percent of the employee's contribution each month. The matching contributions are usually limited to a set percentage of the employee's pay.
While the account is designed for employees to use once they retire, there are circumstances under which money can be withdrawn from the account prior to retirement. However, when money is taken out before retirement it incurs a significant tax penalty. When leaving a company, employees have several options for their 401(k) plan, including rolling it over into a new similar plan sponsored by their new employee, rolling it into an Individual Retirement Account or taking a cash payout. When taking the lump sum payment, however, the money is subject to both federal and state income taxes, as well as a 10 percent early withdrawal penalty.
Types of 401(k) plans
There are several types of 401 (k) plans, each with their own plusses and minuses. The four most common types are:
Traditional 401(k) plan: Considered the most flexible of all the plans, the Traditional 401(k) plan allows employees to make pre-tax contributions through payroll deductions. Under this type of plan, employers have the option of making contributions on behalf of all participants, matching contributions made by employees, or both. With Traditional 401 (k) plans, employers have the right to reclaim the contributions they make on behalf of an employee if they leave the company before a set time. In order to sponsor a Traditional 401(k) plan, businessesneed to pass annual tests, known as the Actual Deferral Percentage and Actual Contribution Percentage tests, to ensure they meet the Internal Revenue Code's standards and requirements.
Safe Harbor 401(k) plan: The Safe Harbor plan is similar to the Tradition plan, except that it mandates that employer contributions must be vested as soon as they are made. This gives employees the ability to take the money with them when they leave the company, regardless of how long they have been there. Unlike the Traditional plan, the Safe Harbor 401(k) does not require employers to pass any type of annual testing.
Simple 401(k) plan: Designed for smaller ventures, Simple 401(k) plans can only be offered by businesses with fewer than 100 employees. Like the Safe Harbor plan, the Simple plan requires employer contributions be vested as soon as they are made, and isn't not subjected to annual testing. [Related: New 401(k) Plan Targets Small Businesses]
Roth 401(k) plan: Unlike other plans where pre-tax contributions are made, Roth 401(k) plans are funded with after-tax dollars. However, unlike the other plans where the earnings are taxed when they are withdrawn, money saved via a Roth 401(k) plan is not subjected to any federal or state taxes as long as the investor reaches the age of 59 and a half.
History of 401(k) plans
Named after a section of the Internal Revenue Code, 401(k) provisions were originally spelled out in the Tax Revenue Act of 1978. However, it wasn'tuntil two years later that the retirement plans started being used. It was in 1980 when Pennsylvania benefit consultant Ted Benna figured out how the tax provision could be used to create a simple employee retirement savings plan. While the client Benna had devised the plan for eventually passed on it, the program began to take off, and eventually had its rules and regulations formally described by the Internal Revenue Service in 1981. While participation in 401(k) programs started off slow, it has since evolved into the most common employer-sponsored retirement plan in the United States. Today, the 401(k) retirement system holds $2.8 trillion in assets on behalf of more than 50 million active participants and millions of former employees and retirees.