Subject: Retirement Plans - 401(k)
Last-Revised: 17 February 2019
Contributed-By: Ed Nieters (nieters at crd.ge.com), David W. Olson, Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris Lott (contact me), Art Kamlet (artkamlet at aol.com), Ed Suranyi, Ed Zollars, Rick Meigs
A 401(k) plan is a retirement savings plan that is funded by employee contributions and (often) matching contributions from the employer. The major attraction of these plans is that the contributions are taken from pre-tax salary, and the funds grow tax-free until withdrawn. Also, the plans are (to some extent) self-directed, and they are portable; more about both topics later. Both for-profit and many types of tax-exempt organizations can establish these plans for their employees.
Rules and regulations for 401(k) plans are established by the US tax code. In fact, a 401(k) plan takes its name from the section of the Internal Revenue Code of 1978 that created them. The IRS says what can be done, but the operation of these plans is regulated by the Employee Benefits Security Administration of the U.S. Department of Labor. To get a bit picky for a moment, a 401(k) plan is a plan qualified under Section 401(a) (or at least we mean it to be). Section 401(a) is the
For example, the Widget Company's plan might permit employees to contribute up to 7% of their gross pay to the plan, and the company then matches the contributions at 50% (happily, they pay in cash and not in widgets :-). Total contribution to the Widget plan in this example would be 10.5% of the employee's salary. My joke about paying in cash is important, however; some plans contribute stock instead of cash.
There are many advantages to 401(k) plans. First, since the employee is allowed to contribute to his/her 401(k) with pre-tax money, it reduces the amount of tax paid out of each pay check. Second, all employer contributions and any growth in the capital grow tax-free until withdrawal. The compounding effect of consistent periodic contributions over the period of 20 or 30 years is quite dramatic. Third, the employee can decide where to direct future contributions and/or current savings, giving much control over the investments to the employee. Fourth, if your company matches your contributions, it's like getting extra money on top of your salary. Fifth, unlike a pension, all contributions can be moved from one company's plan to the next company's plan (or to an IRA) if a participant changes jobs. Sixth, because the program is a personal investment program for your retirement, it is protected by pension (ERISA) laws. This includes the additional protection of the funds from garnishment or attachment by creditors or assigned to anyone else, except in the case of domestic relations court cases dealing with divorce decree or child support orders (QDROs; i.e., qualified domestic relations orders). Finally, while the 401(k) is similar in nature to an IRA, an IRA won't enjoy any matching company contributions, and personal IRA contributions are subject to much lower limits; see the article about IRA's elsewhere in this FAQ.
There are, of course, a few disadvantages associated with 401(k) plans. First, it is difficult (or at least expensive) to access your 401(k) savings before age 59 1/2 (but see below). Second, 401(k) plans don't have the luxury of being insured by the Pension Benefit Guaranty Corporation (PBGC). (But then again, some pensions don't enjoy this luxury either.) Third, employer matching contributions are usually not vested (i.e., do not become the property of the employee) until a number of years have passed. The rules say that employer matching contributions must vest according to one of two schedules, either a 3-year "cliff" plan (100% after 3 years) or a 6-year "graded" plan (20% per year in years 2 through 6).
Participants in a 401(k) plan generally have a decent number of different investment options, nearly all cases a menu of mutual funds. These funds usually include a money market fund, bond funds of varying maturities (short, intermediate, long term), and various stock funds Some plans may allow investments in company stock, US Series EE Savings Bonds, and others. The employee chooses how to invest the savings and is typically allowed to change where current savings are invested and/or where future contributions will go a specific number of times a year. This may be quarterly, bi-monthly, or some similar time period. The employee is also typically allowed to stop contributions at any time.
With respect to participant's choice of investments, expert (sic) opinions from financial advisors typically say that the average 401(k) participant is not aggressive enough with their investment options. Historically, stocks have outperformed all other forms of investment and will probably continue to do so. Since the investment period of 401(k) savings is relatively long - 20 to 40 years - this will minimize the daily fluctuations of the market and allow a "buy and hold" strategy to pay off. As you near retirement, you might want to switch your investments to more conservative funds to preserve their value.
Rules and Regulations
Puzzling out the rules and regulations for 401(k) plans is difficult simply because every company's plan is different. The law requires that if low compensated employees do not contribute enough by the end of the plan year, then the limit is changed for highly compensated employees. Practically, this means that the employer sets a maximum percentage of gross salary in order to prevent highly compensated employees from reaching the limits. In any case, the employer chooses how much to match, how much employees may contribute, etc. Of course the IRS has the final say, so there are certain regulations that apply to all 401(k) plans. We'll try to lay them out here.
Let's begin with contributions. Employees have the option of making all or part of their contributions from pre-tax (gross) income. This has the added benefit of reducing the amount of tax paid by the employee from each check now and deferring it until the person takes the pre-tax money out of the plan. Both the employer contribution (if any) and any growth of the fund compound tax-free. According to the Department of Labor regulations, these contributions must be deposited quite rapidly, something like 7 business days after the end of the month in which they were made. Also see a link at the end of this article for details.
The interesting rules govern what happens to before-tax and after-tax contributions. The IRS limits pre-tax deductions to a fixed dollar figure that changes annually. In other words, an employee in any 401(k) plan can reduce his or her gross pay by a maximum of some fixed dollar amount via contributions to a 401(k) plan. An employer's plan may place restrictions on the employees that are stricter than the IRS limit.
After-tax contributions are quite different from pre-tax contributions. If an employee elects to make after-tax contributions, the money comes out of net pay (i.e., after taxes have been deducted). While it doesn't help the employee's current tax situation, funds that were contributed on an after-tax basis may be easier to withdraw since they are not subject to the strict IRS rules which apply to pre-tax contributions. When distributions are begun (see below), the employee pays no tax on the portion of the distribution attributed to after-tax contributions, but does have to pay tax on any gains.
Ok, let's talk about the IRS limits already. First, a person's maximum before-tax contribution (i.e., 401(k) limit) for 2019 is $19,000, up $500 from 2018. It's important to understand this limit. This figure indicates only the maximum amount that the employee can contribute from his/her pre-tax earnings to all of his/her 401(k) accounts. It does not include any matching funds that the employer might graciously throw in. Further, this figure is not reduced by monies contributed towards many other plans (e.g., an IRA). And, if you work for two or more employers during the year, then you have the responsibility to make sure you contribute no more than that year's limit between the two or more employers' 401k plans. If the employee "accidentally" contributes more than the pre-tax limit towards his or her 401(k) account, the employee must contact the employer. The excess might be refunded, or might be reclassified as an after-tax contribution.
The maximum before-tax contribution limit is subject to the catch-up provision, which is available to employees who are over 50 years old. This provision allows these employees to contribute extra amounts over and above the limit in effect for that year. The additional contribution amount is $6,000 in 2019 (unchanged from 2018).
Next there are regulations for highly compensated employees. What are these? Well, when the 401(k) rules were being formulated, the government was afraid that executives might make the 401(k) plan at their company very advantageous to themselves, but without allowing the rank-and-file employees those same benefits. The only way to make sure that the plan would be beneficial to ordinary employees as well as those "highly compensated," the law-writers decided, was to make sure that the executives had an incentive to make the plan desirable for those ordinary employees. What this means is that employees who are defined as "highly compensated" within the company (as guided by the regulations) may not be allowed to save at the maximum rates. As of 2019 the IRC defines "highly compensated" as income in excess of $125,000 (up from 120,000 in 2018); alternately, the company can make a determination that only the top 20% of employees are considered highly compensated. Therefore, the implementation of the "highly compensated employee" regulations varies with the company, and only your benefits department can tell you if you are affected.
And here are the last of the IRS regulations, the so-called "415 limits." First, contributions can only be made on pay up to a certain amount, which changes annually. The 2019 limit is $280,000 (up from 275K in 2018). The IRS further limits the total amount for defined contribution plans (i.e., money put into 401(k) plans, 401(a) plans, or pension plans) each year to the lesser of 100% of annual compensation, or some magic number. For 2019, the magic number is $56,000 (up from 55K in 2018). Annual compensation is defined as gross compensation for the purpose of computing the limitation. This changes an earlier law; a person's annual compensation for the purpose of this computation is no longer reduced by 401(k) contributions and salary redirected to cafeteria benefit plans.
Withdrawal and Loan Rules
Unlike IRA or other retirement-saving accounts, 401(k) plans allow limited, penalty-free access to savings before age 59 1/2. One option is taking a loan from yourself! It is legal to take a loan from your 401(k) before age 59 1/2. The tax code does not specify exactly what loans are permitted, just that loans must be made reasonably available to all participants. The employer can restrict loans for purposes such as covering unreimbursed medical expenses, buying a house, or paying for education. When a loan is obtained, you must pay the loan back with regular payments (these can be set up as payroll deductions) but you are, in effect, paying yourself back both the principal and the interest, not a bank. If you take a withdrawal from your 401(k) as money other than a loan, not only must you pay tax on any pre-tax contributions and on the growth, you must also pay an additional 10% penalty to the government. There are other special conditions that permit withdrawals at various ages without penalty; consult an expert for more details.
Should you ever take a loan from your 401(k) plan? Here's a brief discussion of the pros and cons. The pros are that it's convenient (no credit check or lengthy approval process), the interest rate is relatively low (a few points over the prime rate), and you pay the interest to yourself (not a bank or credit card). The cons are that your money is not growing for you while it is out of your account, there may be fees involved, the loan must be paid back immediately if you change jobs, and a loan default is treated as an early withdrawal (with taxes and penalties due). Given the total lack of job security that most workers have as of this writing, there are considerable risks to this type of loan.
Participants who are vested in 401(k) plans can begin to access their savings without withdrawal penalties at various ages, depending on the plan and on their own circumstances. If the participant who separates from service is age 55 or more during the year of separation, the participant can draw any amount from the 401(k) without any calculated minimums and without any 5-year rules. Depending on the plan, a participant may be able to draw funds without penalty at or after age 59 1/2 regardless of whether he or she has separated from service (i.e., the participant might still be working; check with the plan administrator to be sure). The minimum withdrawal rules for a participant who has separated from service kick in at age 70 1/2. Being able to draw any amount and for any length of time without penalty starting at age 55 (provided the person has separated from service) is one of the least understood differences between 401ks and IRAs. Note that this paragraph doesn't mention "retire" because the person's status after leaving service with the company that has the 401(k) doesn't seem to be relevant.
Anyone who has separated from service from a company with a 401(k), and is entitled to withdraw funds without penalty, may take a lump sum withdrawal of the 401(k) into a taxable account. Until 1999, the tax laws allowed people to use an income averaging method to spread that lump sum over five years for tax purposes. However, that option is no longer available; the entire withdrawal must be reported to the IRS as income in the year of the withdrawal. Alternately, an entire account can be transferred directly from the 401(k) custodian to an IRA custodian, and the account will continue to grow tax deferred.
Participants in 401(k) plans must begin taking distributions by age 70 1/2, just like participants in IRA plans. Also, the IRS imposes a minimum annual distribution on 401(k)s at age 70 1/2, just to guarantee that Uncle Sam gets his share. However, there's a wage-slave exception to the minimum required distribution rules: if you own less than 5% of the company that maintains the plan, you continue to work at that same company, and the 401(k) is still there, you do not have to start the required distributions based on reaching age 70 1/2. And note that 401(k) distributions are separate from pension funds.
Since a 401(k) is a company-administered plan, and every plan is different, changing jobs will affect your 401(k) plan significantly. Different companies handle this situation in different ways (of course). Some will allow you to keep your savings in the program until age 59 1/2. This is the simplest idea. Other companies will require you to take the money out. Things get more complicated here, but not unmanageable. Your new company may allow you to make a "rollover" contribution to its 401(k) which would let you take all the 401(k) savings from your old job and put them into your new company's plan. If this is not a possibility, you may roll over the funds into an IRA. However, as discussed above, a 401(k) plan has numerous advantages over an IRA, so if possible, rolling 401(k) money into another 401(k), if at all possible, is usually the best choice.
Whatever you do regarding rollovers, BE EXTREMELY CAREFUL!! This can not be emphasized enough. Legislation passed in 1992 by Congress added a twist to the rollover procedures. It used to be that you could receive the rollover money in the form of a check made out to you and you had a 60 days to roll this cash into a new retirement account (either 401(k) or IRA). Now, however, employees taking a withdrawal have the opportunity to make a "direct rollover" of the taxable amount of a 401(k) to a new plan. This means the check goes directly from your old company to your new company (or new plan). If this is done (ie. you never "touch" the money), no tax is withheld or owed on the direct rollover amount.
If the direct rollover option is not chosen, i.e., a check goes through your grubby little hands, the withdrawal is immediately subject to a mandatory tax withholding of 20% of the taxable portion, which the old company is required to ship off to the IRS. The remaining 80% must be rolled over within 60 days to a new retirement account or else is is subject to the 10% tax mentioned above. The 20% mandatory withholding is supposed to cover possible taxes on your withdrawal, and can be recovered using a special form filed with your next tax return to the IRS. If you forget to file that form, however, the 20% is lost. Naturally, there is a catch. The 20% withheld must also be rolled into a new retirement account within 60 days, out of your own pocket, or it will be considered withdrawn and subject to the 10% tax. Check with your benefits department if you choose to do any type of rollover of your 401(k) funds.
Here's an example to clarify an indirect rollover. Let us suppose that you have $10,000 in a 401k, and that you withdraw the money with the intention of rolling it over - no direct transfer. Under current law you will receive $8,000 and the IRS will receive $2,000 against possible taxes on your withdrawal. To maintain tax-exempt status on the money, $10,000 has to be put into a new retirement plan within 60 days. The immediate problem is that you only have $8,000 in hand, and can't get the $2,000 until you file your taxes next year. What you can do is:
- Find $2,000 from somewhere else. Maybe sell your car.
- Roll over $8,000. The $2,000 then loses its tax status and you will owe income tax and the 10% tax on it.
What happens if you wish to roll over an account with both pre-tax and post-tax contributions? The custodian is likely to issue two checks (or make two transfers). One check, the big one, represents the pre-tax contributions plus the gain resulting from both pre-tax and after-tax contributions, and is made out directly to the new custodian. The second check, the smaller one, represents the after-tax contributions that have basis and is usually made out to the account holder personally. Both sums *can* be rolled into the new account. However, unlike the original employer's plan custodian that kept track of the split between pre-tax and post-tax dollars, the next trustee (account custodian) likely will not accept an explanation of the split in the rolled-in money. You, the account owner, will have to keep careful records in a safe and enduring location that document these amounts so eventual withdrawals are taxed appropriately. The after-tax check is *not* free money; it must be rolled over also, otherwise tax and possibly penalties are due on the pre-tax portion of that check, which is considered ordinary income. Some advisors recommend putting the after-tax check into a separate account. This is not harmful, but it does not change the required calculation that happens at withdrawal time. The account holder cannot choose to take withdrawals exclusively from a pre-tax or post-tax bucket, the IRS rules just don't allow it. At withdrawal time you have to calculate the portion of each withdrawal that is pre-tax and post tax. Here's an example calculation using an original rollover amount of $100K, of which $75K is pre-tax and $25K is after-tax dollars. The account grows to $150K, and at that point a distribution of $10K is taken. The percent of the account that is post-tax contribution is 25K (the basis) divided by 150K (the current value) or 16.7%. So 16.7% of the $10K distribution ($1,667) is post-tax contribution and not taxable, the rest is taxable. Finally, the new amount in the account that is post-tax contribution is 25K less the 1,667, or $23,333. The after-tax amount can be tracked on IRS form 8606, which also has this same calculation on it.
Caveat: If you have been in an employee contributed retirement plan since before 1986, some of the rules may be different on those funds invested pre-1986. Consult your benefits department for more details.
The rules changed at the end of 1999 to disallow income averaging of lump-sum withdrawals over five years.
Here are some resources on the web that may help.
- The Employee Benefits Security Administration of the
U.S. Department of Labor offers some (although not much) information.
- Tax Topic 424 from the IRS on 401k Plans
- Fidelity offers an introduction to 401k plans
- Pamela Perdue and the 401k Help Center offer a very technical
discussion of when an employer must send contributions to a plan.
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