From Wikipedia, the free encyclopedia
A
401(k) plan is the common name in the USA for the tax-qualified,
defined-contribution pension account defined in subsection
401(k) of the
Internal Revenue Code.
Under the plan, retirement savings contributions are provided (and
sometimes proportionately matched) by an employer, deducted from the
employee's paycheck before taxation (therefore
tax-deferred until withdrawn during retirement), and limited to a maximum pre-tax annual contribution of $17,500 (as of 2013).
[1][2]
Alternative employer-provided defined-contribution pensions include
403(b) and
401(a), offering higher mandatory limits.
History
The section of the Internal Revenue Code that made 401(k) plans possible was enacted into law in 1978.
[3]
It was intended to allow taxpayers a break on taxes on deferred income.
In 1980, a benefits consultant named Ted Benna took note of the
previously obscure provision and figured out that it could be used to
create a simple, tax-advantaged way to save for retirement. The client
he was working for at the time chose not to create a 401(k) plan.
[4] He later went on to install the first 401(k) plan at his own employer, The Johnson Companies
[5] (today doing business as Johnson Kendall & Johnson).
[6]
Tax consequences
Employees can make contributions to the 401(k) on a pre-tax or
post-tax basis, depending on what the plan allows. With either pre-tax
or after-tax contributions, earnings from investments in a 401(k)
account (in the form of interest, dividends, or capital gains) are
tax-deferred. The resulting compounding interest with delayed taxation
is a major benefit of the 401(k) plan when held over long periods of
time.
[7] Beginning in the 2006 tax year, employees have been allowed to designate contributions as a
Roth 401(k) deduction. Similar to the provisions of a
Roth IRA,
these contributions are made on an after-tax basis and all earnings on
these funds not only are tax-deferred but can be tax-free upon a
qualified distribution. The plan sponsor must amend the plan to make
those options available, however.
For pre-tax contributions, the employee does not pay federal income
tax
on the amount of current income he or she defers to a 401(k) account.
For example, a worker who otherwise earns $50,000 in a particular year
and defers $3,000 into a 401(k) account that year only recognizes
$47,000 in income on that year's tax return. Currently this would
represent a near $750 term saving in taxes for a single worker, assuming
the worker remained in the 25% marginal
tax bracket
and there were no other adjustments (e.g., deductions). The employee
ultimately pays taxes on the money as he or she withdraws the funds,
generally during retirement. The
character of any gains (including tax-favored capital gains) are transformed into "ordinary income" at the time the money is withdrawn.
If the employee made after-tax contributions to the non-Roth 401(k)
account, these amounts are commingled with the pre-tax funds and simply
add to the non-Roth 401(k) basis. When distributions are made the
taxable portion of the distribution will be calculated as the ratio of
the non-Roth contributions to the total 401(k) basis. The remainder of
the distribution is tax-free and not included in gross income for the
year.
For accumulated after-tax contributions and earnings in a designated
Roth account (Roth 401(k)), "qualified distributions" can be made
tax-free. To qualify, distributions must be made more than 5 years after
the first designated Roth contributions
and not before the year
in which the account owner turns age 59½, unless an exception applies as
detailed in IRS code section 72(t). In the case of designated Roth
contributions, the contributions being made on an after-tax basis means
that the taxable income in the year of contribution is not decreased as
it is with pre-tax contributions. Roth contributions are irrevocable and
cannot be converted to pre-tax contributions at a later date.
Administratively, Roth contributions must be made to a separate account,
and records must be kept that distinguish the amount of contribution
and the corresponding earnings that are to receive Roth treatment.
Unlike the Roth IRA, there is no upper income limit capping
eligibility for Roth 401(k) contributions. Individuals who find
themselves disqualified from a Roth IRA may contribute to their Roth
401(k). Individuals who qualify for both can contribute the maximum
statutory amounts into both plans (including both catch-up contributions
if applicable).
Withdrawal of funds
Virtually all employers impose severe restrictions on withdrawals of
pre-tax or Roth contributions while a person remains in service with the
company and is under the age of 59½. Any withdrawal that is permitted
before the age of 59½ is subject to an
excise tax
equal to ten percent of the amount distributed (on top of the ordinary
income tax that has to be paid), including withdrawals to pay expenses
due to a hardship, except to the extent the distribution does not exceed
the amount allowable as a deduction under Internal Revenue Code section
213 to the employee for amounts paid during the taxable year for
medical care (determined without regard to whether the employee itemizes
deductions for such taxable year).
[8]
In any event any amounts are subject to normal taxation as ordinary
income. Some employers may disallow one, several, or all of the previous
hardship causes. Someone wishing to withdraw from such a 401(k) plan
would have to resign from their employer. To maintain the tax advantage
for income deferred into a 401(k), the law stipulates the restriction
that unless an exception applies, money must be kept in the plan or an
equivalent tax deferred plan until the employee reaches 59½ years of
age. Money that is withdrawn prior to the age of 59½ typically incurs a
10% penalty tax unless a further exception applies.
[9] This penalty is on top of the "ordinary income" tax that has to be paid on such a withdrawal.
[10]
The exceptions to the 10% penalty include: the employee's death, the
employee's total and permanent disability, separation from service in or
after the year the employee reached age 55,
substantially equal periodic payments under section 72(t), a
qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor). This does not apply to the similar
457 plan.
Many plans also allow employees to take
loans from their 401(k) to be repaid with after-tax funds at pre-defined
interest rates.
The interest proceeds then become part of the 401(k) balance. The loan
itself is not taxable income nor subject to the 10% penalty as long as
it is paid back in accordance with section 72(p) of the Internal Revenue
Code. This section requires, among other things, that the loan be for a
term no longer than 5 years (except for the purchase of a primary
residence), that a "reasonable" rate of interest be charged, and that
substantially equal payments (with payments made at least every calendar
quarter) be made over the life of the loan. Employers, of course, have
the option to make their plan's loan provisions more restrictive. When
an employee does not make payments in accordance with the plan or IRS
regulations, the outstanding loan balance will be declared in "default".
A defaulted loan, and possibly accrued interest on the loan balance,
becomes a taxable distribution to the employee in the year of default
with all the same tax penalties and implications of a withdrawal.
These loans have been described
[by whom?]
as tax-disadvantaged, on the theory that the 401(k) contains before-tax
dollars, but the loan is repaid with after-tax dollars. While this is
precisely correct, the analysis is fundamentally flawed with regard to
the loan principal amounts. From your perspective as the borrower, this
is identical to a standard loan where you are not taxed when you get the
loan, but you have to pay it back with taxed dollars. However, the
interest portion of the loan repayments, which are essentially
additional contributions to the 401k, are made with after-tax funds but
they do not increase the after-tax basis in the 401k. Therefore, upon
distribution/conversion of those funds the owner will have to pay taxes
on those funds a second time.
[11]
Required minimum distributions (RMD)
Account owners must begin making distributions from their accounts by
April 1 of the calendar year after turning age 70½ or April 1 of the
calendar year after retiring, whichever is later. The amount of
distributions is based on life expectancy according to the relevant
factors from the appropriate IRS tables.
[12]
There is an exception to minimum distribution for people still working
once they reach that age. The exception only applies to the current plan
they are participating in and does not apply if the account owner is a
5% owner of the business sponsoring the retirement plan.
[13]
Required minimum distributions apply to both pretax and after-tax Roth
contributions. Only a Roth IRA is not subject to minimum distribution
rules. Other than the exception for continuing to work after age 70½
differs from the rules for IRA minimum distributions. The same penalty
applies to the failure to make the minimum distribution. The penalty is
50% of the amount that should have been distributed, one of the most
severe penalties the IRS applies. In response to the economic crisis,
Congress suspended the
RMD requirement for 2009.
Force-out
Former employees ("terminated participants") can have their 401(k)
accounts closed if their account balances are low; such a provision in
the plan is referred to as a "force-out" provision. Almost 90% of plans
have a force-out provision.
[14]
As of March 2005, the limit for force-out provisions is a balance of
$1,000—participants whose balance is over $1,000 cannot have their
account closed. Before March 2005, the limit was $5,000.
Closing an account requires that the participant either roll-over the
funds to an IRA, another 401(k) plan or take a distribution ("cash
out"). 85% of those with balances of under $1,000 cash out, either
voluntarily or due to a force-out provision.
Rollovers
Direct rollovers
A direct rollover from an eligible retirement plan to another
eligible retirement plan is not taxable, regardless of the age of the
participant.
[15]
Traditional to Roth rollovers
Beginning in 2013 the IRS has begun allowing conversions of existing
Traditional 401(k) contributions to Roth 401(k). In order to do so an
employee's company plan must offer both a Traditional and Roth option,
and explicitly permit such a conversion.
[16]
Technical details
Contribution deferral limits
There is a maximum limit on the total yearly
employee pre-tax
or Roth salary deferral into the plan. This limit, known as the "402(g)
limit", was $15,500 for the year 2008, $16,500 for 2009–2011, $17,000
for 2012, and $17,500 for 2013-2014.
[17][18][19][20]
For future years, the limit may be indexed for inflation, increasing in
increments of $500. Employees who are 50 years old or over at any time
during the year are now allowed additional pre-tax "catch up"
contributions of up to $5,000 for 2008 and $5,500 for 2009–2014. The
limit for future "catch up" contributions may also be adjusted for
inflation in increments of $500. In eligible plans, employees can elect
to contribute on a pre-tax basis or as a Roth 401(k) contribution, or a
combination of the two, but the total of those two contributions amounts
must not exceed the contribution limit in a single calendar year. This
limit does not apply to post-tax non-Roth elections.
If the employee contributes more than the maximum pre-tax/Roth limit
to 401(k) accounts in a given year, the excess as well as the deemed
earnings for those contributions must be withdrawn or corrected by April
15 of the following year. This violation most commonly occurs when a
person switches employers mid-year and the latest employer does not know
to enforce the contribution limits on behalf of their employee. If this
violation is noticed too late, the employee will not only be required
to pay tax on the excess contribution amount the year was earned, the
tax will effectively be doubled as the late corrective distribution is
required to be reported again as income along with the earnings on such
excess in the year the late correction is made.
Plans which are set up under section 401(k) can also have employer
contributions that cannot exceed other regulatory limits. Employer
matching contributions can be made on behalf of designated Roth
contributions, but the employer match must be made on a pre-tax basis.
[21]
Some plans also have a profit-sharing provision where employers make
additional contributions to the account and may or may not require
matching contributions by the employee. These additional contributions
may or may not require a matching employee contribution to earn them.
These profit-sharing contributions plus the matching contributions both
cannot exceed 25% of the employee's pre-tax compensation. As with the
matching funds, these contributions are also made on a pre-tax basis.
There is also a maximum 401k contribution limit that applies to all
employee and employer 401k contributions in a calendar year. This limit
is the section 415 limit, which is the lesser of 100% of the employee's
total pre-tax compensation or $44,000 for 2006, $45,000 for 2007,
$46,000 for 2008, $49,000 for 2009–2011, $50,000 for 2012, $51,000 for
2013, and $52,000 for 2014. For employees over 50, the catch-up
contribution limit is also added to the 415 limit.
Governmental employers in the US (that is, federal, state, county,
and city governments) are currently barred from offering 401(k) plans
unless they were established before May 1986. Governmental organizations
instead can set up a section 457(b).
Contribution deadline
For a corporation, or LLC taxed as a corporation, contributions must
be made by the end of a calendar year. For a sole proprietorship,
partnership, or an LLC taxed as a sole proprietorship, the deadline for
depositing contributions is generally the personal tax filing deadline
(April 15, or September 15 if an extension was filed).
Highly compensated employees (HCE)
To help ensure that companies extend their 401(k) plans to low-paid
employees, an IRS rule limits the maximum deferral by the company's
"highly compensated" employees, based on the average deferral by the
company's non-highly compensated employees. If the less compensated
employees are allowed to save more for retirement, then the executives
are allowed to save more for retirement. This provision is enforced via
"non-discrimination testing". Non-discrimination testing takes the
deferral rates of "highly compensated employees" (HCEs) and compares
them to non-highly compensated employees (NHCEs). An HCE in 2008 is
defined as an employee with compensation of greater than $100,000 in
2007 or an employee that owned more than 5% of the business at any time
during the year or the preceding year.
[22]
In addition to the $100,000 limit for determining HCEs, employers can
elect to limit the top-paid group of employees to the top 20% of
employees ranked by compensation.
[22]
That is for plans whose first day of the plan year is in calendar year
2007, we look to each employee's prior year gross compensation (also
known as 'Medicare wages') and those who earned more than $100,000 are
HCEs. Most testing done now in 2009 will be for the 2008 plan year and
compare employees' 2007 plan year gross compensation to the $100,000
threshold for 2007 to determine who is HCE and who is a NHCE. The
threshold was $110,000 in 2010 and it did not change for 2011.
[23] For 2012,2013 and 2014, the threshold was increased from $110,000 to $115,000.
The average deferral percentage (ADP) of all HCEs, as a group, can be
no more than 2 percentage points greater (or 125% of, whichever is
more) than the NHCEs, as a group. This is known as the ADP test. When a
plan fails the ADP test, it essentially has two options to come into
compliance. It can have a return of excess done to the HCEs to bring
their ADP to a lower, passing, level. Or it can process a "qualified
non-elective contribution" (QNEC) to some or all of the NHCEs to raise
their ADP to a passing level. The return of excess requires the plan to
send a taxable distribution to the HCEs (or reclassify regular
contributions as catch-up contributions subject to the annual catch-up
limit for those HCEs over 50) by March 15 of the year following the
failed test. A QNEC must be an immediately vested contribution.
The annual contribution percentage (ACP) test is similarly performed
but also includes employer matching and employee after-tax
contributions. ACPs do not use the simple 2% threshold, and include
other provisions which can allow the plan to "shift" excess passing
rates from the ADP over to the ACP. A failed ACP test is likewise
addressed through return of excess, or a QNEC or qualified match (QMAC).
There are a number of "
safe harbor"
provisions that can allow a company to be exempted from the ADP test.
This includes making a "safe harbor" employer contribution to employees'
accounts. Safe harbor contributions can take the form of a match
(generally totaling 4% of pay) or a non-elective profit sharing
(totaling 3% of pay). Safe harbor 401(k) contributions must be 100%
vested at all times with immediate eligibility for employees. There are
other administrative requirements within the safe harbor, such as
requiring the employer to notify all eligible employees of the
opportunity to participate in the plan, and restricting the employer
from suspending participants for any reason other than due to a hardship
withdrawal.
Automatic enrollment
Employers are allowed to automatically enroll their employees in
401(k) plans, requiring employees to actively opt out if they do not
want to participate (traditionally, 401(k)s required employees to opt
in). Companies offering such automatic 401(k)s must choose a default
investment fund and savings rate. Employees who are enrolled
automatically will become investors in the default fund at the default
rate, although they may select different funds and rates if they choose,
or even opt out completely.
[24]
Automatic 401(k)s are designed to encourage high participation rates
among employees. Therefore, employers can attempt to enroll
non-participants as often as once per year, requiring those
non-participants to opt out each time if they do not want to
participate. Employers can also choose to escalate participants' default
contribution rate, encouraging them to save more.
[25]
The
Pension Protection Act of 2006
made automatic enrollment a safer option for employers. Prior to the
Pension Protection Act, employers were held responsible for investment
losses as a result of such automatic enrollments. The Pension Protection
Act established a safe harbor for employers in the form of a "Qualified
Default Investment Alternative", an investment plan that, if chosen by
the employer as the default plan for automatically enrolled
participants, relieves the employer of financial liability. Under
Department of Labor regulations, three main types of investments qualify
as QDIAs: lifecycle funds, balanced funds, and managed accounts. QDIAs
provide sponsors with fiduciary relief similar to the relief that
applies when participants affirmatively elect their investments.
[26]
Fees
401(k) plans charge fees for administrative services, investment
management services, and sometime outside consulting services. They can
be charged to the employer, the plan participants or to the plan itself
and the fees can be allocated on a per participant basis, per plan, or
as a percentage of the plan's assets. For 2011, the average total
administrative and management fees on a 401(k) plan was 0.78 percent or
approximately $250 per participant.
[27]
Plans for certain small businesses or sole proprietorships
The
Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA) made 401(k) plans more beneficial to the self-employed. The
two key changes enacted related to the allowable "Employer" deductible
contribution, and the "Individual" IRC-415 contribution limit.
Prior to EGTRRA, the maximum tax-deductible contribution to a 401(k)
plan was 15% of eligible pay (reduced by the amount of salary
deferrals). Without EGTRRA, an incorporated business person taking
$100,000 in salary would have been limited in Y2004 to a maximum
contribution of $15,000. EGTRRA raised the deductible limit to 25% of
eligible pay without reduction for salary deferrals. Therefore, that
same businessperson in Y2008 can make an "elective deferral" of $15,500
plus a profit sharing contribution of $25,000 (i.e. 25%), and—if this
person is over age 50—make a catch-up contribution of $5,000 for a total
of $45,500. For those eligible to make "catch-up" contribution, and
with salary of $122,000 or higher, the maximum possible total
contribution in 2008 would be $51,000. To take advantage of these higher
contributions, many vendors now offer
Solo 401(k) plans or Individual(k) plans,
which can be administered as a Self-Directed 401(k), allowing for
investment into real estate, mortgage notes, tax liens, private
companies, and virtually any other investment.
Note: an unincorporated business person is subject to slightly
different calculation. The government mandates calculation of profit
sharing contribution as 25% of
net self-employment (Schedule C) income.
Thus on $100,000 of self-employment income, the contribution would be
20% of the gross self-employment income, 25% of the net after the
contribution of $20,000.
Rollovers as business start-ups (ROBS)
ROBS is an arrangement in which prospective business owners use their
401k retirement funds to pay for new business start-up costs.
[28] ROBS is an acronym from the United States
Internal Revenue Service for the IRS ROBS
Rollovers as Business Start-Ups Compliance Project.
ROBS plans, while not considered an abusive tax avoidance
transaction, are questionable because they may solely benefit one
individual – the individual who rolls over his or her existing
retirement 401k withdrawal funds to the ROBS plan in a tax-free
transaction. The ROBS plan then uses the rollover assets to purchase the
stock of the new business. A
C corporation must be set up in order to roll the 401k withdrawal.
Other countries
Even though the term "401(k)" is a reference to a specific provision
of the U.S. Internal Revenue Code section 401, it has become so well
known that it has been used elsewhere as a generic term to describe
analogous legislation. For example, in October 2001,
Japan
adopted legislation allowing the creation of "Japan-version 401(k)"
accounts even though no provision of the relevant Japanese codes is in
fact called "section 401(k)."
[29][30][31][32]
The term is not used in the
UK, where analogous pension arrangements are known as
personal pension schemes.
Risk
Unlike defined benefit
ERISA
plans or banking institution savings accounts, there is no government
insurance for assets held in 401(k) accounts. Plans of sponsors
experiencing financial difficulties, sometimes have funding problems.
[citation needed]
Fortunately, the bankruptcy laws give a high priority to sponsor
funding liability. In moving between jobs, this should be a
consideration by a plan participant in whether to leave assets in the
old plan or roll over the assets to a new employer plan.
