401k into IRA; The rollover process explained

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401k to IRA can be a rather simple process if you follow the easy steps provided below in this article. Moreover, we will discuss the advantages and disadvantages to a 401k to IRA rollover.

But first, let us provide a background as to why one might choose to move from a 401k into an IRA; There are numerous reasons why people should consider rolling over their 401k into a Roth IRA or a traditional IRA, likely because they have either lost their job, switched jobs, or moving onto retirement. Below are the reasons why it makes sense to move that 401k into IRA:

  • With your old 401k your options are limited to whatever the company allowed. Moving a 401k to IRA allows you complete and instant flexibility with regards to your money.
  • It really doesn’t make sense to be bound to a small set of the market, a 401k to IRA allows you access to numerous options you didn’t have. Consider this: Typical companies only provide one investment company in which to use and they typically have no more than 15 to 20 different funds to pick from – if there are better options out there it wouldn’t make sense to stay tied to someone that doesn’t offer the best service. Don’t let someone tell you what to do with your money by limiting your options to a small set of funds or bonds or the like.
  • Most employer plans don’t allow you to buy individual stocks, whereas an IRA provides that flexibility.
  • If you were to decide to simply rollover your 401k into another 401k with your new employer, you won’t necessarily be able to take advantage of being able to control your money – as once again you will be limited by your new employers rules and policies.
  • If you were to simply leave the money with the existing plan sponsor, there maybe restrictions as to your ability to continue and contribute to the plan. If you’re retired it may not matter to you, but if you’re moving onto another job – or even looking for another job – it only makes sense to move that 401k into IRA and take control of your money immediately. Not to mention, you may have the ability with a 72t to make extended regular withdrawals, penalty free from an IRA, which you can’t do with your 401k.

Now, it would be a lie if we didn’t explain to you that there are certain disadvantages to moving a 401k into IRA, and they are as follows:

  • Most 401k plans allow you to borrow from your accumulated assets, while you do not have that option if you put your 401k into IRA.
  • You may not be able to hold onto that company stock that you’ve accumulated and you may be forced to sell it.

Now, if you’re convinced that moving your 401k to IRA investments is a good idea, you can take the following steps to get the ball rolling:

  • Contact  an investment company such as Vanguard, Fidelity, or even contact your local bank to see what options they provide.
  • Open an IRA and choose which funds to allocate your 401k proceeds to.
  • Then your plan sends the assets over.

The process really is that simple.  It’s clear to us here at 401k Maze, the pluses out weigh the minuses when it comes to rolling your 401k to IRA.  It only makes sense to weigh your options and decide what is right for you, whether that be leave your money sitting where it is (which we don’t recommend in most instances), or move that 401k into an IRA and take back control of your money – we feel you are leaving money on the table by leaving your money with an former employer. The fact is, the major reason for participating in their plan to begin with was to take advantage of the matching contributions – not necessarily to take advantage of their investment options. don’t wait another minute, the fact is, you’re probably losing money by doing so.


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Top 5 stocks for your investment portfolio – Small Cap edition

The stock market has rebounded as the DJIA has risen from a low in the beginning of March when it was teetering just below 6500 points. We’ve gained back nearly 3000 points in less than six months. However, some companies have still been struggling, while others are prospering and booming. Below, we’ll take a look at 5 companies with a market capitalization of at least 100 million, but below 1.5 billion (small cap stocks), and who were the best stocks year to date:

1. Kirkland’s (KIRK): This small cap specialty retail home decor store chain has seen their stock price shoot up nearly 500% over the past year. Watch out though, recent earnings reports indicate this stock may have hit it’s peak. If people are going to be stuck in their house, it seems logical they want to look at nice things.

2. China Green Agriculture, Inc (CGA): Everyone knows organics are trendy, so how couldn’t we have seen organic fertilizers as being a smart business; especially considering the heart of their business is China, with a country population of 1.4 billion people. A recent pull back in price makes this 335% gainer an attractive buy once again. Keep in mind though, organic consumption is dropping while consumers cut back on everything possible. This small cap stock is worth looking into further.

3. STEC, Inc. (STEC) has seen their stock price triple over this year, and they don’t look like a simple flash and dash. Flash drives is their core business, and their technologies are gaining them a competitive advantage. Their stock price is up over 200% and with a market cap around two billion, these guys will be around for a while.But remember folks, buy low and sell high. They just might be at their peak.

4. Isramco, Inc. (ISRL) is a natural gas exploring, crude oil pumping money maker. Their small cap company has seen their stock double in these tough times. Watch out though, rumors on the block are these guys are being investigated for securities fraud.

5. American Dairy, Inc. (ADY) operates in China offering unique dairy products to fulfill special dietary needs of a massively diverse population. These guys have been around the block for over 5 years and hit a wall earlier this year, however, they have since seen a steady increase in their share prices over the last month or so. Their recent earnings release was mixed, but all indicators point to this stock showing promise.


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What Can I Do With My 401(k) If I’ve Been Laid Off?

It’s a complex World isn’t it? They say the recession is global now and that means you are not alone when laid off. So don’t take it personal but do take a key decision on your 401 (k). Basically you have 3 options.

1) Do nothing and leave your 401(k) funds in your ex-employers plan.
2) Take the money and run.
3) Roll your contributions over into another qualified individual retirement account (IRA).

If your employer gives you the necessary information to properly choose your options, then good! If he doesn’t however, be sure to call the fund administrator and get the facts.

A really important thing to know is whether you are fully ‘vested’. The money you paid out of your monthly salary is always yours, but your employers’ contributions will depend on your tenure. If you’ve been at this workplace for years rather than months then you’re most likely 100% vested.
Lots of people take option 1 and leave their 401(k) with their ex employer fund because it is the easy thing to do. However it is probably not the wisest course of action. Your former employer will no longer want the trouble and costs of administering your account. You may be billed for it. You will no longer be entitled to the support of the fund administrators. You will not be able to take out loans against your 401(k) either. Finally there is always the danger that you may lose track of your account, especially if you move a long distance away.
There is a big penalty to pay if you take the cash from your 401(k) account. Your employer will automatically take 20% for the IRS before sending you your check. Failure on your part to place your funds into another qualifying IRA within 2 months of withdrawing will also make you liable for tax and a 10% early withdrawal penalty. Only people older than 59 years and 6 months are exempt from this.
So in truth option 3, rolling over to a new IRA, is the best option. You will be required to make up the 20% deduction but you can get this back through your next tax return. If you are fortunate enough to find another job more or less immediately you can do a direct rollover from your old 401(k) to the new one. Simply notify your old employer of the address and they will forward a check without fuss, taxes or withholding charge.
If you are not so fortunate and have to find an IRA you will have to take an ‘indirect’ rollover. The check made out t o you for 80% of your entitlement. I.e. minus 20% withheld by the employer and now with the IRS. You can reclaim this amount but you are still subject to the 10% early withdrawal penalty and taxes.


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What is a solo 401k plan? Who provides these and who are they for? How do I get one?

The solo 401 (k is the business retirement plan for the sole proprietor. The solo 401(k) has undergone many changes in the past 3 years. All of the solo 401 (k) changes are beneficial to the lone businessperson. The aim of the changes is to encourage take up of the plans and provide for the retirement time of the self-employed.
The most attractive enhancement is the much bigger tax-deductible yearly threshold. The gains for the sole proprietor is that they can rapidly build up a significant tax-deferred retirement fund at the same time as minimizing their annual income tax payments.
For sole proprietors who want to maximize the contributions to a deductible retirement account these changes are a big improvement. This is because a solo 401(k) allows annual contributions in two parts, doubling the benefits.
In the first place you can add to your fund up to 100% of the first $16,500 of your 2009 earnings or self-employment income. To help people over 50 to catch up this amount is $22,000.
In the second place you can contribute and tax deduct an extra 25% of your salary or 20% of your self-employment earnings. So to put it in numbers your boss pays you $80,000 2009. The maximum tax-deductible solo 401(k) account deposit could be $36,500 i.e. $16,500 + 25% of $80,000.
Then perhaps you earn $80,000 from your single business ownership. If you are over 50 your maximum solo 401(k) funds for 2009 can be $42,000 $22,000 + 25% x $80,000 and $38,000.
If you earn more than $80,000 your solo 401(k) contributions can be even more but there is a cap for 2009 of $49,000, or $54,500 if you turn 50 before the year-end.
The amount you contribute to your retirement fund is flexible. You can put in the maximum during the good years while paring it back during the lean years. It does require lone business people to be proactive in planning for their future however. So remember that nobody is as interested in your solo 401 (k) as you are.

There are a large number of solo 401 (k) plan sellers operating now. There number of providers is growing and it will pay to shop around because they differ in terms and conditions and fees. Many of them specialize in particular occupational sectors too. For more information and a full list go to www.401khelpcenter.com/small_business_index.html.


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401(k) Rules For Rollover.

There are a large number of 401(k) rules that are aimed at protecting both the contributors and beneficiaries of these popular pension plans. Here are some of the most frequently asked questions about 401(k) funds.

What happens to my contributions when I change employers? It does not matter why you leave a job you can and should take your 401(k) fund contributions (either all or part) with you and place them into your new employer sponsored retirement plan. When you do this it is called a rollover withdrawal.

Can I rollover my 401(k) fund to an IRA? Yes. In some ways an Individual Retirement Account gives you more choices and control over how your pension money is invested. The 401(k) fund has just seven ways to invest your money.

What is the best way to rollover my 401(k) contributions? The trustee-to-trustee transfer or a direct rollover is the easiest, quickest and best way to rollover your 401(k) fund. Especially since you get to keep the 20% tax withholding.

What happens if I don’t rollover my 401(k) fund? If your retirement fund is paid directly to you, you become liable to pay taxes and a tax fine. You have a 60-day window in which to complete the rollover into your new IRA account and you must transfer 100% of your funds. This includes the 20% withheld by the 401(k) administrator. You still owe the tax, but if you do transfer the 20% withheld from your funds, you can include the 20% deferred as income tax paid. It is very important when you know you are going to change employer that you talk to both your 401(k) administrator and the IRA advisers to be sure you know and follow the rules and protect your retirement income.

How much money can I put into my 401(k) fund? There is a maximum contribution of $15,000 and this ceiling goes up each year in $500 increments. The absolute maximum amount put in to your 401(k) plan is the lesser of 100% compensation or $42,000.

Can I make extra contributions to my 401(k) fund? Yes if you become 50 or older by the end of the year, you can put in “catch-up” contributions annually. The maximum “catch-up” contribution is $5,000.
However you can only put money in to your 401(k) plan with automatic salary deductions.

If I leave my job after a short time, will I still get my employer matching money? Possibly not if you stay with your employer for under three years. However, many companies are offering immediate vesting benefits to employees


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401(k) Plans For Employees And Employers.


The responsibility for keeping money rolling into households in retirement is shared between individual employees and their employers. A 401(k) fund can be the best choice for an employer plan while a self-directed 401(k) can maximize the control exercised by individuals.

The 401(k) employer plan differs from the traditional fixed monthly payment plan in that it has preset contribution levels. This means that employees are required to invest their salaries and to be actively involved in guiding and adjusting those investments. 401(k) funds are now the dominant employer plan in the public sector. They are classified, by the IRS, as ‘profit-sharing’. However they do not necessarily involve true profit sharing.

Other types of retirement provision are available to employers such as the 403(b) for employees in educational and not for profit organizations, or Employee Stock Ownership Plans and profit-sharing ones.

401(k) funds offer tax deductions and flexibility in both the way the plan is set up and in the investments that individuals decide to make. 401(k) self-directed funds differ from the traditional a pension plan in that workers keep the benefits when they change employer. They are also insured against the bankruptcy of the contributing employer.

The choice of 401(k) fund structure is the first and most fundamental decision to be made when an employer establishes a fund. There are three distinct types of 401(k) plans:

  • A ‘Simple’ 401(k) fund is the best option for small to medium sized companies with fewer employees who received a minimum of $5,000 in pay in the previous year. Employees can only draw contributions or benefits accruals from this plan from the one employer. These kinds of 401(k) fund are not subject to nondiscrimination reviews that aim to ensure fairness of benefits between workers, owners and managers.
  • ‘Traditional’ 401(k) funds is where employers can make matching contributions to employees’ deferrals. Companies can apply a ‘vesting schedule’ that sets minimum service periods before a getting the matched contributions. Employees who join the fund make deductions direct from their salary. Each year reviews are done to ensure that workers get proportional benefits in line with owners and managers.
  • A ‘Safe Harbor’ 401(k) fund is like a traditional plan, but the tax rules are much simpler and the employer contributions have to be fully vested from the start. Not subject to annual nondiscrimination testing

The justification for establishing and joining employer/employee retirement funds is a lot about the time when tax is paid. In most 401(k) funds, employees put a proportion of their salary in to the plan before income taxes are deducted. The capital growth and interest on the funds is also not subject to tax deductions. Only when the retirees make withdrawals are they subject to tax.


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Starting A 401(k) Is Just As Sexy As George Clooney!


Financial adviser: “We think you should begin to invest for your retirement as soon as possible. What you need now is to start a 401(k)!”

New employee: “A pair of designer jeans? I know they last well but how will that help me provide for myself in old age”?

Financial adviser: “No no, a 401(k) plan is a saving plan that allows you to invest for the future and defer some of the tax on those savings and the earnings now”.

New employee:” I’m suspicious of things that don’t tell me what they are up-front, especially big government things. What have they ever done for me, except tax me”?

Financial adviser: “It is good to be skeptical in money matters but participants who start a 401(k) plan do so through their employers. Always start a 401(k) that has proper amendments. This means you can put aside some or all of your contributions to a separate special ‘Roth’ account, commonly known as a Roth 401(k). Let me explain a little about starting a 401(k) plan and you see if you can come up with a better name for it. Ok?”

New employee: “Ok I guess, you’re the expert, but I don’t want to waste a lot of my time getting buried under paperwork. I don’t think starting a 401(k) would appeal to me even if you called it George Clooney!”

“So let’s see if we can’t change your mind. Qualifying investments from a designated Roth account are tax-free. This means that your contributions into them have the income tax withheld on the income in the year you contributed. So are your employers matching contributions because they are also putting money into your retirement investment fund?

In addition to Roth and pre-tax contributions, some participating employees may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax and so may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account is taxed as income tax.

So to start a 401(k) is to gain in 3 important ways. 1) You are saving and investing in your future. 2) Your contributions are being matched by your employer and often this means investing in your employer too. 3) You are saving on tax payments.

Here is another non-sexy name for you. The ERISA or Employment Income Security Act of 1974 gives responsibility for managing your 401(k) investments to named trustees from within your employing company. So it is people like you looking after your money and making safe investment decisions. The investments are in a mixture of mutual funds but with reliance on low risk stocks and bonds. You can even have a say in which stocks to invest in”.

New employee: “Let me summarize. The 401(k) is safe long-term financial plan that is between my employer and me and gives me big tax deferments until I draw from the fund in my retirement. Hey! That sounds like a good deal all round. They should think about calling it George Clooney. They’re both amazing figures! And they’re both my idea of a dream come true!”


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My work is going bankrupt, what will happen to my 401k and benefit plan?

401(k) plans are tax-qualified plans covered by ERISA such that assets held by the plans are generally protected from creditors of the account holder, which in the past was generally not true for IRA plans. In the case of employer bankruptcy, all 401(a) (pension and defined contribution plans) and 401(k) plans are protected, because of the rule that contributions must accrue to the exclusive benefit of employees in general. Even though pension plans are backed by insurance through the Pension Benefit Guaranty Corporation, workers whose company enters bankruptcy may not receive the full value of their pension. ERISA protection of 401(k) assets does not extend to losses in the value of investments that participants choose. Employees investing their 401(k) in their own employer stock face the possibility of losing the value of their retirement accounts that is invested in employer stock along with their jobs if their employer goes out of business.


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Roth 401k plan

The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A [1], and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b) retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001).

Traditional 401(k) and Roth IRA plans

In a traditional 401(k) plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called “elective deferrals“. That is, an employee’s elective deferral funds (currently up to $15,500 per tax year for those under age 50 and $20,500 for those over) are set aside by the employer in a special account where the funds are allowed to be invested in various options made available in the plan.

Employers may also add funds to the account by contributing matching funds on a fractional formula basis (e.g., matching funds might be added at the rate of 50% of employees’ elective deferrals), or on a set percentage basis. Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59-and-a-half, they may begin to receive “qualified distributions” from the funds in the account; these distributions are then taxed at ordinary income tax rates. Exceptions exist to allow distribution of funds before 59 and a half, such as Substantially equal periodic payments, disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).

Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement(IRA). In contrast to the 401k plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59 and a half. The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2008, individuals are limited to contributing no more than $5,000 to a Roth IRA, if under age 50, and $6,000, if age 50 or older. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly). Here is a 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.

The Roth 401(k) plan

The Roth 401(k) combines some of the most advantageous aspects of both the 401(k) and the Roth IRA. Under the Roth 401(k), employees can decide to contribute funds on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401(k) plans. An employee’s combined elective deferrals– whether to a traditional 401(k), a Roth 401(k), or to both– cannot exceed $15,500 for tax year 2008 if a participant is under 50; if they are over 50, they may contribute an additional $5,000. Employer’s matching funds are not included in the $15,500 elective deferral cap, but are considered for the maximum section 415 limit, which is $46,000 for 2008. Employers are permitted to match contributions to a designated Roth account, but the matching funds must be made on a pre-tax basis, not be made into the designated Roth account, and cannot receive the Roth tax treatment. (Pub 4530)

In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre tax dollars are those which do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least 5 years after the first Roth contribution and the attainment of age 59 and one half, unless an exception applies.

A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket upon reaching retirement age. The Roth 401(k) offers the advantage of tax free distribution, but is not constrained by income limitations. For example, normal Roth IRA contributions are limited to $5,000; whereas, up to $15,500 could be contributed to a Roth 401(k) account, provided no other elective deferrals were taken for the tax year (no traditional 401(k) deferrals taken).

Adoption of Roth 401(k) plans has been relatively slow, and stated reasons for this include the fact that they require additional administrative recordkeeping and payroll processing[1]. However some larger firms have now adopted Roth 401(k) plans, and this is expected to spur their adoption by other firms including smaller ones[2].

Additional considerations

  • Roth 401(k) contributions are irrevocable, such that once money is invested into a Roth 401(k) account; it cannot be moved to a regular 401(k) account.
  • Employees are able to roll their Roth 401(k) contributions over to a Roth IRA account upon termination of employment.
  • It is the employer’s decision as to whether the company will provide access to the Roth 401(k) in addition to the traditional 401(k). Many employers may feel that the added administrative burden outweighs the benefits of the Roth 401(k)
  • The Roth 401(k) plan will now be available after December 31, 2010 since the Pension Protection Act of 2006 was passed to extend the program. The program was originally set up to sunset, or no longer be in place, after 2010 along with the rest of EGTRRA 2001.
  • Unlike Roth IRAs, owners of Roth 401(k) accounts (designated Roth accounts) must begin distributions upon reaching age 70 and a half, similar to required minimum distributions for IRA and other retirement plans. (Pub 4530)

See also

  • 401(k) IRA matrix – 401k & IRA comparisons (401k vs Roth 401k vs Traditional IRA vs Roth IRA)

Roth 401k vs 401k

The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A [1], and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b) retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001),

In the United States of America, a 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or “deferred,” into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many companies’ 401(k) plans also offer the option to purchase the company’s stock. The employee can generally re-allocate money among these investment choices at any time. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan’s assets will be invested.

Some assets in 401(k) plans are tax deferred. Before the January 1, 2006, effective date of the designated Roth account provisions, all 401(k) contributions were on a pre-tax basis (i.e., no income tax is withheld on the income in the year it is contributed), and the contributions and growth on them are not taxed until the money is withdrawn. With the enactment of the Roth provisions, participants in 401(k) plans that have the proper amendments can allocate some or all of their contributions to a separate designated Roth account, commonly known as a Roth 401(k). Qualified distributions from a designated Roth account are tax free, while contributions to them are on an after-tax basis (i.e., income tax is paid or withheld on the income in the year contributed). In addition to Roth and pre-tax contributions, some participants may have after-tax contributions in their 401(k) accounts. The after-tax contributions are treated as after-tax basis and may be withdrawn without tax. The growth on after-tax amounts not in a designated Roth account are taxed as ordinary income.

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Details

As an employee benefit, a 401(k) must be sponsored by an employer, typically a private sector corporation. A self-employed individual can set up a 401(k) plan, and, until 1986, a government entity could do so as well. The employer is responsible for creating and designing the plan. And while ERISA (Employee Retirement Income Security Act of 1974) defaults reporting and disclosure to the plan sponsor, there is no default for a fiduciary, and the plan sponsor must either identify at least one “named fiduciary” in the plan document or it must write a procedure into the plan for appointing the named fiduciary. While ERISA defaults total discretion and control over plan assets and investments to the plan’s trustee, many plan sponsors override this default structure by giving responsibility for selecting and monitoring plan investments to the named fiduciary, often a committee of internal employees, or a mix of internal employees and outside persons bringing in particular fiduciary expertise.

A 401(k) plan is a type of defined contribution plan (under the IRS’s definition). It is a salary reduction plan, where employees must choose a percentage of their salary to contribute to the plan, and the plan spells out the extent of employer matching, if any (regardless of profits). Employee taxable salaries are reduced by these contributions, the contributions are invested, and any earnings are tax-deferred, i.e., until the employee draws the money out at retirement. Two other types of defined contribution plans are profit-sharing plans, in which the plan specifies, for example, that the employer will contribute 10% of net profits each year (divided among participant accounts), and money purchase pension plans, in which the plan defines the contribution as 10% of participants’ annual salary, for example. 401(k) plans are not a defined benefit plan, because the benefit formula (specifying what participants will receive at retirement) is not spelled out in the plan. 401(a) profit sharing plans and money purchase pension plans, and 401(k) plans, are individual account plans, because each participant’s benefit is the value of an individual account to which the contributions have been made plus any investment income and less any losses. If investments do well, there will be more in the account at retirement; if investments do poorly, there will be less.

In addition, 401(k) plans are tax-qualified plans covered by ERISA such that assets held by the plans are generally protected from creditors of the account holder, which in the past was generally not true for IRA plans. In the case of employer bankruptcy, all 401(a) (pension and defined contribution plans) and 401(k) plans are protected, because of the rule that contributions must accrue to the exclusive benefit of employees in general. Even though pension plans are backed by insurance through the Pension Benefit Guaranty Corporation, workers whose company enters bankruptcy may not receive the full value of their pension. ERISA protection of 401(k) assets does not extend to losses in the value of investments that participants choose. Employees investing their 401(k) in their own employer stock face the possibility of losing the value of their retirement accounts that is invested in employer stock along with their jobs if their employer goes out of business.

Defined benefit plans have a definitely determinable benefit amount that usually has a fixed formula, regardless of how the underlying plan assets perform. Defined contribution plans according to Section 414(i) of the IRC have individual accounts. Because plan sponsors want to take advantage of the exemption from the fiduciary duty to diversify plan assets to minimize the risk of large losses by using ERISA Section 404(c), these plans usually provide each worker the ability to control the contents of his account. The account value may fluctuate in value based on the underlying investments. There is a risk that returns may even be negative.

Some companies match employee contributions to some extent, paying extra money into the employee’s 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing contributions into the 401(k) plan or just contribute a fixed percentage of wages. These contributions may vest over several years as an inducement to the employee to stay with the employer.

When an employee leaves a job, the 401(k) account generally stays active for the rest of his or her life, though the accounts must begin to be drawn out beginning the April 1st of the calendar year after the attainment of age 70½ (except that under SBJPA 1996, those still employed can defer). In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company.[citation needed] Alternatively, when the employee leaves the company, the account can be rolled over into an IRA at an independent financial institution, or if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can “roll over” the account into a new 401(k) account hosted by the new employer.

Comparable types of salary-deferral retirement plans include 403(b) plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and 457 plans which cover employees of state and local governments and certain tax-exempt entities.

Significant new rules are allowing benefits companies (Plan Providers) and those involved in selling benefits to plans (Plan Advisors) to expand their capabilities to sell services to Plan Sponsors (those responsible for managing employer-sponsored retirement plans for companies).

Tax consequences

Most 401(k) contributions are on a pre-tax basis. Starting in the 2006 tax year, employees can either contribute on a pre-tax basis or opt to utilize the Roth 401(k) provisions to contribute on an after tax basis and have similar tax effects of a Roth IRA. However, in order to do so, the plan sponsor must amend the plan to make those options available. 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 not taxable events. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over long periods of time.

For pre-tax contributions, the employee does not pay federal income tax on the amount of current income that he or she defers to a 401(k) account. For example, a worker who 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 term $750 savings 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.

For after tax contributions to 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 59 and a half, 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 that are to receive Roth treatment.

Withdrawal of funds

Virtually all employers impose severe restrictions on withdrawals 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 twenty percent of the amount distributed, 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).

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.[1] This penalty is on top of the “ordinary income” tax that has to be paid on such a withdrawal. 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 as tax-disadvantaged, on the theory that the 401(k) contains before-tax dollars, but the loan is repaid with after-tax dollars. This is not correct. The loan is repaid with after-tax dollars, but the loan itself is not a taxable event, so the “income” from the loan is tax-free. This treatment is identical to that of any other loan, as long as the balance is repaid on schedule. (A residential mortgage or home equity line of credit may have tax advantages over the 401(k) loan; but that is because the interest on home mortgages is deductible, and unrelated to the tax-deferred features of the 401(k).)

Required minimum distributions

An account owner must begin making distributions from their accounts at least no later than the year after the year the account owner turns 70½ unless the account owner is still employed at the company sponsoring the 401(k) plan. The amount of distributions is based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. Required minimum distributions apply to both pre-tax 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.

History

In 1978, Congress amended the Internal Revenue Code, later called section 401(k), whereby employees are not taxed on income they choose to receive as deferred compensation rather than direct compensation.[2] The law went into effect on January 1, 1980,[2] and by 1983 almost half of large firms were either offering a 401(k) plan or considering doing so.[2] By 1984 there were 17,303 companies offering 401(k) plans.[2] Also in 1984, Congress passed legislation requiring nondiscrimination testing, to make sure that the plans did not discriminate in favor of highly paid employees more than a certain allowable amount.[2] In 1998, Congress passed legislation that allowed employers to have all employees contribute a certain amount into a 401(k) plan unless the employee expressly elects not to contribute.[2] By 2003, there were 438,000 companies with 401(k) plans.[2]

Originally intended for executives, the section 401(k) plan proved popular with workers at all levels because it had higher yearly contribution limits than the Individual Retirement Account (IRA); it usually came with a company match, and in some ways provided greater flexibility than the IRA, often providing loans and, if applicable, offered the employer’s stock as an investment choice. Several major corporations amended existing defined contribution plans immediately following the publication of IRS proposed regulations in 1981.

A primary reason for the explosion of 401(k) plans is that such plans are cheaper for employers to maintain than a defined benefit pension for every retired worker. With a 401(k) plan, instead of required pension contributions, the employer only has to pay plan administration and support costs if they elect not to match employee contributions or make profit sharing contributions. In addition, some or all of the plan administration costs can be passed on to plan participants. In years with strong profits employers can make matching or profit-sharing contributions, and reduce or eliminate them in poor years. Thus 401(k) plans create a predictable cost for employers, while the cost of defined benefit plans can vary unpredictably from year to year.

The danger of the 401(k) plan is if the contributions are not diversified, particularly if the company had strongly encouraged its workers to invest their plans in their employer itself. This practice violates primary investment guidelines about diversification. In the case of Enron, where the accounting scandal and bankruptcy caused the share price to collapse, there was no PBGC insurance and employees lost the money they invested in Enron stock. Congress inserted trust law fiduciary liability upon employers who did not prudently diversify plan assets to avoid the chance of large losses inside Section 404 of ERISA, but it is unclear whether such fiduciary liability applies to trustees of plans in which participants direct the investment of their own accounts.

Technical details

Contribution Limits

There is a maximum limit on the total yearly employee pre-tax salary deferral. The limit, known as the “402(g) limit”, is $15,500 for the year 2008 and $16,500 for 2009.[3] 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. The limit for future “catch up” contributions may also be adjusted for inflation in increments of $500. In eligible plans, employees can elect to have their contribution allocated as either a pre-tax contribution or as an after tax Roth 401(k) contribution, or a combination of the two. The total of all 401(k) contributions must not exceed the maximum contribution amount.

If the employee contributes more than the maximum pre-tax limit to 401(k) accounts in a given year, the excess must be withdrawn by April 15th 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 may have to pay taxes and penalties on the excess. The excess contribution, as well as the earnings on the excess, is considered “non-qualified” and cannot remain in a qualified retirement plan such as a 401(k).

Plans which are set up under section 401(k) can also have employer contributions that (when added to the employee contributions) cannot exceed other regulatory limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, which is the lesser of 100% of the employee’s compensation or $44,000 for 2006, $45,000 for 2007, $46,000 for 2008, and $49,000 for 2009. Employer matching contributions can be made on behalf of designated Roth contributions, but the employer match must be made on a pre-tax basis.[4]

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(g).

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 rank and file saves 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. 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 2008 will be for the 2007 plan year when we compare employees’ 2006 plan year gross compensation to the $95,000 threshold for 2006 to determine who is HCE and who is a NHCE.

The average deferral percentage (ADP) of all HCEs, as a group, can be no more than 2% greater (or 150% of, whichever is less) 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 15th 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 totalling 4% of pay) or a non-elective profit sharing (totalling 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.

401(k) plans for certain small businesses or sole proprietorships

Many self-employed persons felt (and financial advisors agreed) that 401(k) plans did not meet their needs due to the high costs, difficult administration, and low contribution limits. But 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 $15,000 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 $45,000. For those eligible to make “catch up” contribution,and with salary of $136,000 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.

Other countries

The term “401(k)” has no intrinsic meaning; it is a reference to a specific provision of the U.S. Internal Revenue Code section 401. However the term has become so well-known (it is almost a “brand“) that some other nations use it as a generic term to describe analogous legislation. E.g., 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).” India, Hong Kong, Singapore, and Malaysia refer to their equivalents of the U.S. 401(k) plan as Provident Funds. Egypt and Lebanon have a similarly structured retirement fund, and Israel has its own retirement fund.