401(K) Plans 101: The Basics
Since its creation in the late 1970’s, the 401(K) has become the go-to choice for employers looking to offer their employees a retirement plan.
Prior to its creation, most employers used what is called a defined-benefit plan, where the employer set aside a certain sum of money in a trust fund that was used to provide a predetermined amount of benefits to its employees upon retirement.
A pension is a type of defined-benefit plan.
As people began living longer after retiring, these plans became extremely expensive to maintain.
Rather than continuing to finance these benefits themselves, employers began utilizing what are called defined-contribution plans, where the employee is primarily responsible for funding the retirement account and determining how its assets are invested.
Enter the 401(k) plan.
Contributions to a 401(k) are made by the employee, with the employer matching none of, a percentage of, or all of an employees contribution, at their discretion.
As of 2012, an employee can contribute up to $17,000 per year ($22,500 if you are age 50 or older. This is called a “catch-up contribution”).
Contributions are tax-deductible, and are usually withdrawn directly from your paycheck.
401(k) plan assets continue to grow tax-deferred until you choose to withdraw the funds from the account, at which time the entire withdrawal amount is taxable at your ordinary income tax rate, and may or may not be subject to a 10% penalty if withdrawn before age 59 1/2.
The reason that a penalty is charged for withdrawing funds from the account prior to 59 1/2 is to discourage people from using their 401(K) as a personal bank account. These are retirement accounts, and should be treated as such.
Note: Certain withdrawals prior to the age of 59 1/2 are permitted without incurring the 10% penalty. Here is a list of qualified withdrawal purposes that do not result in the 10% penalty.
All 401(k) plans have what is called a plan provider (sometimes called a plan administrator).
A plan provider is the organization that provide the platform through which you deposit, invest, withdraw, and communicate with the 401(k).
Some of the larger plan providers in the United State are Fidelity, Vanguard, and Charles Schwab.
From an employee viewpoint, the plan providers importance is most applicable when making investments in your 401(k), and when withdrawing money from your 401(k).
The reasons for this are that the plan provider is the organization that “provides” the investment options are available within the plan.
When you choose to make an investment in your 401(k) account, you do not do it through your employer, you do it through the plan provider, either over the phone or through their website.
They also provide educational materials to explain the different types of investments available, but do not typically assist you in choosing the most appropriate investments for your account.
Additionally, when you retire or otherwise leave your company, the plan provider is who you will communicate with to withdraw or rollover your 401(k) assets.
As mentioned above, the plan provider provides you with the investment options within your 401(k)
While the options vary from company to company, one constant remains true: They are limited.
This is not necessarily a bad thing.
The rationale behind this is to simplify the process for plan participants.
Rather than having 10,000 investment options and create confusion for employees (which may discourage them from contributing to the plan, which defeats the purpose of the 401(k) altogether), many employers and plan providers limit the number of options.
This not only makes the investment selection process easier and less confusing for employees, but it also keeps the fees of the plan lower than they might otherwise be.
Withdrawal Versus Rollover
A withdrawal is different than a rollover.
A withdrawal involves removing assets from the 401(K) with the anticipation that you will either use the funds, or put them into a taxable bank/investment account. By doing this, you lose the tax-deferral benefits of the 401(k).
A rollover, on the other hand, involves moving 401(k) assets into either another 401(k) plan, or an IRA, both of which maintain the tax-deferral of the assets.
A withdrawal creates a taxable event, while a rollover does not.
Withdrawals are made for any number of reasons.
They are made to fund retirement expenses, fund a college education, or are sometimes made in the case of financial hardship where no other alternative exists.
Rollovers are typically made when an employee leaves a company, and is therefore no longer eligible to contribute to that employers plan.
Often times a new employer will allow an old 401(k) to be “rolled” into their 401(k) plan.
In the event this is not allowed, or in the event an employee wants more investment options, rolling over a 401(k) into an IRA may be more appropriate.
Most 401(k) plans allow you to take a loan out of your 401(k) balance.
Because this is a loan and not a withdrawal, you will not be taxed, and you will not incur the 10% penalty.
Additionally, while there is interest on the loan, you pay the interest to yourself (the interest is added to your 401(k) balance).
401(k) loans can be a great way to access funds in times of need, but also carry with them inherent dangers.
The largest downfall occurs if you leave your employer, or are otherwise terminated from your employment while there is a loan outstanding, you ordinarily have to repay the loan in full within 60 days.
If you are unable to do so, the loan becomes treated as a withdrawal, and you will be subject to taxes, and if appropriate the 10% penalty.
Financial Planning Implications
From a planning perspective, it is important to determine how much of your income you should contribute to your 401(k), how the assets within the plan should be allocated, and how your consolidated asset allocation looks when taking into account any other assets you may have.
Is it better to continue funding your 401(k), or is deferring some assets to a Roth IRA a better route?
Should you own a particular investment within your 401(k), or is it better to allocate that asset to a taxable account?
How and where you allocate assets to is not a one-size-fits all discussion, and you should diligently explore your options prior to making any decisions.
While this post discussed the basics of the 401(k) plan, there are many intricacies to discuss that are well beyond the scope of this post.
If there is anything you would like discussed in more detail, or if you have any questions, chances are others do as well.
Don’t hesitate to leave a comment below and I will reply in more detail.