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The Revenue Act of 1978 created new retirement options for employee benefit plans.
Under section 401(k) of the Internal Revenue Code, employers may offer their employees two options of saving their current income until retirement. Employees may elect to save or defer a portion of their income on either a pre-tax or after-tax basis. Profit-sharing plans, savings plans, and stock bonus plans may include provisions for 401(k)s. This tutorial will cover 401(k) plans as retirement tools.
We will look at four areas of 401(k)s:
MAKING CONTRIBUTIONS
Contributions to a 401(k) plan can take several forms:
Employee Contributions- these are contributions the employee makes to the plan with after-tax dollars. This type of plan is sometimes referred to as a "thrift plan."
Matching Contributions- these are contributions that an employer makes to an employee's plan after the employee has contributed. For example, an employer may deposit 50% of the employee's first 10% deferral; in other words, the employer may deposit 5% if the employee deposits 10%, so that 15% is deposited for the employee.
Elective Contributions- these are before-tax contributions made by an employee. Elective contributions are limited to no more than 15% of total compensation.
Non-Elective Contributions- these are funds that are automatically put into the plan by the employer. The employee is not allowed to receive them alternatively as cash.
REQUIREMENTS OF 401(K) PLANS
A 401(k) plan has certain requirements:
1. The plan must be part of a qualified stock bonus plan or profit sharing plan. (A grandfather clause allows a pre-1974 money purchase pension plan to include 401(k) provisions. The Employee Retirement Income Security Act was passed in 1974 and altered many rules on pension plans.)
2. Distributions are allowed for the following events:
- Termination of employment
- Retirement (Age 59 ½ for most plans)
- Certain hardships (such as medical expenses or college tuition)
- Death or disability
3. Eligibility requirements can be set for minimum age and service (for example, employees 21 and older with 1,000 hours of service).
4. Generally, contributions (employee and employer) are limited to less than of 25% of the employee's compensation or $30,000. Employer contributions are not required, and employers have flexibility in matching their employees' contributions.
OTHER ASPECTS OF 401(K) PLANS
Besides requirements, 401(k) plans have extra properties:
1. As long as all employees are covered by the plan, there is no minimum number of employees needed for a plan to exist. (Employees covered by a collective bargaining agreement may be excluded.)
2. Employees are always 100% vested, which is the right of the employee to take his or her accumulated pension money out of the fund, in their elective deferrals. Vesting of non-elective (employer) contributions is subject to a schedule depending on the terms of the plan.
3. All 401(k) contributions (employer and employee) are deductible to the company.
4. Employee contributions may not exceed 15% of compensation or $10,000 (as of 1999) or $10,500 (as of 2000).
Read below to learn about another type of 401(k), called the SIMPLE 401(k).
SIMPLE 401(K) PLANS
Employers may set up SIMPLE IRAs under section 401(k) plans. This is an alternative to the regular 401(k). The SIMPLE plan is much easier to administer, but it has greater limitations.
Under a SIMPLE 401(k), a custodian holds the assets of the plan. The employee may defer $6,000 under a SIMPLE 401(k), compared to $10,000 under a regular 401(k). Under a SIMPLE 401(k), the employer may match up to 3% of the employee elective deferrals. Alternatively, the employer may elect to make a 2% (non-matching) contribution (limited to $160,000 of compensation).
The 401(k) is a very popular retirement plan because both employers and employees can contribute without taxation.
This concludes the tutorial on 401(K)s. For information on related
topics check out tutorials such as Individual
Retirement Accounts and The Roth IRA.
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