What is a 401k Plan?
A 401k plan refers to a tax deferred retirement plan in which employees allocate a certain portion of their salary for long-term investments. A matching contribution is made by the employer but only up to a certain limit.
- The contributions are made by the employees from their salaries, and matching contributions are also made by employers up to a certain limit.
- The contributions made are eligible for tax benefits, and tax is deferred until withdrawal or other conditions as may be prescribed.
- There are restrictions on the withdrawal of money up to the attainment of a certain age, failing which tax penalty shall be levied.
- There are various investment options available to the employee for investment through the amounts lying in a fund.
How Does it Work?
- The contributions are made by the participant employees, and they decide the contributions that they want to make to the fund by way of deduction from their salary. However, the maximum contribution that can be made depends on the annual limits set by the IRS.
- Apart from that, contributions are also made by the employer to the fund. Though the plan is operated by the employer (known as Plan Sponsor), the employees are free to decide as per their will, the investments they want to make, and make decisions with respect to investment management.
401k Plan Example
Let us take an example where a company offers the plan to its employees. The salary of a particular employee is $1,500. The employee decides that he will make a pre-tax contribution of 10% i.e., $150. The amounts are then invested in securities. Such a plan is a 401k plan.
Types of 401k Plan
#1 – Traditional 401k Plan
In this kind of plan, both the employee and the employer make the contributions. However, in order to discourage employee turnover, employers have the option to forfeit the employer contribution in case the employee leaves the organization before a specified tenure. Also, the matching contributions made for all employees have to be the same without any discrimination. An option is available with the employer to change employer contribution each year.
#2 – Self-Directed 401k Plan
In such a plan, there exist not many restrictions with respect to investment options, and the employee can choose to invest in various options such as stocks, bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually., and so on.
#3 – Safe Harbor 401k Plan
Unlike in traditional options, there is no option available to the employer to forfeit the amount in case the employee leaves. Employers can make contributions even if the employee opts out of the plan. There exists an annual limit for employee contributions. Employers are required to satisfy notification requirements as prescribed.
#4 – Tiered Profit-Sharing 401k Plan
In this plan, employees are rewarded based on roles performed by them in the organization. The employer allocates a variable profit share for each employee group based on contributions made by such employees towards the company’s success.
#5 – Simple 401k Plan
The contributions made by the employer and employee remain fully vestedFully VestedFully vested refers to a situation where an investor enjoys full authority and control of every financial instrument (stock options, retirement benefits, profit sharing). It is often followed by a vesting schedule. It is a verified right to the investor and can't be removed from an outsider.. The employer can either make a matching contribution of 3% of the salaries of all employees or make a non-elective contribution of 2% for eligible employees.
Who has 401k access?
It should be noted that not all Americans have access to such plans. In fact, as per a study, it was found that nearly 35% of private-sector employees ageing above 22 don’t work with companies that offer such plans.
401k Maximum Contribution Limits
For the year 2019, the maximum contribution limit for employees under the age of 50 is $19,000 and for employees having an age of 50 or above is $25,000.
Difference Between 401k Plan and Pension Plan
- Pension plans are being funded by the employers, and they ensure regular income to members. Also, the investments in the fund are handled by the investment managers.
- On the other hand, these are funded by the employees. The amounts in the fund depend on deposits made the income arising from the investment therein. Also, the investments are managed by the employees themselves.
Benefits of 401k Plan
- The contributions are on a pre-tax basis, which means that taxation is deferred until withdrawal from the fund.
- Employers make matching contributions or sometimes add profit-sharing features too.
- Employers are required to disclose relevant information about the fund as per statute.
- In case of emergency, an employee can withdraw amounts from the fund after paying a penalty of ten per cent if withdrawal is made before the age of 59.5.
- The contributions are pre-tax.
- The contributions are not counted in calculating income and thereby do not increase your slab rate of tax.
- The tax on incomes generated on the fund is also tax-deferred until they remain vested in the fund.
- An employee can not withdraw the funds before the age of 59.5 years. If they want to withdraw, then they will have to incur a penalty at the rate of ten per cent.
- The employees are compulsorily required to withdraw all the funds lying in the plan after they reach the age of 70.
These plans are of great importance as they offer great tax benefits to the participating employees and provide a great income source at retirement.
This has been a guide to What is 401k Plan & its Definition. Here we discuss the features of the 401k plan, for example, and how it works along with types, benefits, advantages, and disadvantages. You can learn more about from the following articles –