401k and Retirement

The 401(k) plan is a type of retirement plan available in the United States. Named after a section of the 1978 Internal Revenue Code, a 401(k) is an employer-sponsored qualified retirement savings plan. It allows you to save for your retirement while deferring any immediate income taxes on the money you save or their respective earnings until withdrawn. Comparable types of salary-deferral retirement plans include 403(b) plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and 401(a) and 457 plans which cover employees of state and local governments and certain tax-exempt entities.

401(k) plans must be sponsored by an employer, typically a private sector corporation, but self employed individuals can set them up also, and previously government entities could too. The employer acts as a plan fiduciary and is responsible for creating and designing the plan as well as selecting and monitoring plan investments. (In practice, nearly all employers outsource all of this work to one or more financial services companies, such as a bank, mutual fund, third party administrator, or insurance company.)

The employee elects to have a portion of his or her salary paid directly, or "deferred", into their 401(k) account. In trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested. 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.

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. 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 at age 70-1/2. In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, 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, or into an IRA.

Tax benefits and considerations

The employee does not pay federal income taxes 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 is federally taxed as though they had earned only $47,000 in that year, ignoring other deductions. In 2004, this would represent a near term $750 savings in taxes for a single worker, assuming they remained in the 25% marginal tax bracket when taking into account other deductions and adjustments.

Furthermore, all earnings from the investments in a 401(k) account are not taxed until withdrawn. The resulting compound interest without taxation can be a major benefit of the 401(k) plan over the years.

The employee finally pays taxes on the money as they withdraw it, generally after retirement. The taxes are at the "ordinary income" rate, falling into whatever tax bracket the employee is in at the time the money is withdrawn. The assumption is often made that the employee will be in a lower tax bracket in retirement, but this assumption is not always realistic or guaranteed to be correct.

The IRS allows the tax advantage for income deferred into a 401(k), but places the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59 1/2 years of age. Money that is withdrawn prior to 59 1/2 is typically assessed with a 10% penalty tax immediately unless a further exception applies.[1] This penalty is of course 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 being totally and permanently disabled, 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).

One option for withdrawal from a 401(k) while currently employed (and before reaching age 59-1/2) is a hardship distribution with specific hardship rules applying. Hardship withdrawals are subject to the 10% penalty if made before age 59 1/2. Many plans use the hardship "safe-harbor" regulations to decide what expenses allow the employee to use a hardship withdrawal for. These expenses are:

1. Purchase of the primary residence (Specifically excludes mortgage payments)
2. To avoid foreclosure of or eviction from primary residence.
3. Payment of secondary education expenses incurred in the last 12 months for the employee, their spouse or dependent(s).
4. Medical expenses not covered by insurance for employee, their spouse or dependent(s) which would be deductable on a federal tax return (i.e. liposuction would not be acceptable).

Though the law may permit it, some plans do not offer many of the above withdrawal options. For example, some plans do not allow withdrawals for hardship.

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.

History

In 1978, Congress amended the Internal Revenue Code to add section 401 (K); and work on developing the first plans began in 1979. [History of 401(k) Plans: An Update, February 2005 at: http://www.ebri.org/publications/facts/] Originally intended for executives, 401(K) 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 provided greater flexibility in some ways than the (IRA), often providing loans and an employer stock option. Several major corporations amended existing defined contribution plans immediately following the publication of IRS proposed regulations in 1981.

In addition, 401(k) plans are tax-qualified plans covered by the Employee Retirement Income Security Act of 1974 (ERISA), so assets held by the plans are generally protected from creditors, which in the past was generally not true for IRA's.

Much of the reason for the explosion of 401(k) plans was because they are cheaper for employers than maintaining a pension for every retired worker. In most cases, defined contribution plans are less expensive than defined benefit plans for employers. 401(k) plans also create a predictable cost for employers while the cost of defined benefit plans can vary unpredictably from year-to-year.

Technical details

There is a maximum yearly employee pre-tax salary deferral contribution. The limit, known as the "402(g) limit", in 2005 is $14,000. Employees who are 50 years old and over at any time during the year are now allowed additional pre-tax "catch up" contributions of $4,000 in 2005. These amounts will increase to $15,000 and $5,000 respectively for 2006.

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 consider "non-qualified" and cannot remain in a qualifed retirement plan such as a 401(k).

Plans set up under section 401(k) can also have employer contributions that (when added to the employee contributions) can exceed the other regulatory limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, or the lesser of 100% of the employees compensation or $42,000 for 2005. The 415 limit will increase to $44,000 in 2006.

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).

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). A HCE is defined as an employee with compensation of $95,000 or greater in 2005. This limit will change to $100,000 in 2006. The average deferral percentage of all HCEs, as a group, can be no more than 2% greater than the NHCEs, as a group. This is known as the ADP test. When a plan fails the ADP test, it essentially has 2 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 "qualifed non-elective contribution" (QNEC) to 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 requires the plan to give an immediately vested contribution to the NHCEs.

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 Compensation would have been limited in Y2004 to a maximum contribution of $15,000.

EGTRAA raised the deductible limit to 25% of eligible Pay without reduction for Salary Deferrals. Therefore, that same businessperson in Y2004 can defer $13,000, make a profit sharing contribution of $25,000 (i.e 25%), and - if this person is over age 50 - make a catch-up contribution of $3,000 for a total of $41,000 - the maximum allowed under the higher IRC-415 limit.

To take advantage of these higher contributions, many vendors now offer Solo-401(k) plans or Individual(k) plans.

Other Countries

The term "401(k)," a reference to an obscure provision of the U.S. Internal Revenue Code, has become so well-known that other countries are using it to describe similar legislation. For example, in October 2001, Japan adopted legislation allowing the creation of "Japan-version 401(k)" accounts (ÆüËÜÈÇ401(k)) even though no provision of the relevant Japanese codes is in fact called "section 401(k)."

See also Registered Retirement Savings Plan or RSP - Canada by rrd

See also

• Individual retirement account

External links

• Section 401 of the IRS code - From Cornell Law School
• IRS 401k Basics
• About 401k Plans
• PSCA Profit Sharing/401k Advocate Organization
• Financial Planning
• Common 401k Mistakes
• Roth 401(k) Forum: Discuss the new Roth 401(k) coming January 1, 2006
• Roth 401(k) Information: Details about the new Roth 401(k) option coming in 2006

Retirement is the status of a worker who has stopped working. A person may also semi-retire and keep some sort of job, although usually out of choice rather than necessity. This usually happens upon reaching a determined age, when physical conditions don't allow the person to work any more (by illness or accident), or even for personal choice (usually in the presence of an adequate pension). The retirement with a pension is considered a right of the worker in many societies, and hard ideological, social, cultural and political battles have been fought for this right to be granted. In many western countries this right is mentioned in national constitutions.

Retirement age

In most countries, the idea of a fixed retirement age is of recent origin, being introduced during the 19th and 20th centuries - before then, the absence of pension arrangements meant that most workers had to continue to work until death, or rely on the support of family or friends. Nowadays most developed nations have systems to provide pensions on retirement in old age, which may be sponsored by employers or the state. In many poorer countries, support for the old is still mainly provided through the family.

The retirement age varies from country to country but it is generally between 55 and 70. In some countries this age is different for male and females. Sometimes certain jobs, the most dangerous or fatiguing ones in particular, have an earlier retirement age.

Support and funds

Retired workers then support themselves either through superannuation or pensions. In most cases the money is provided by the government, but sometimes granted only by private subscriptions to mutual funds. In this latter case, subscriptions might be compulsory or voluntary. In some countries an additional "bonus" is granted una tantum (once only) in proportion to the years of work and the average wages; this is usually provided by the employer.

The financial weight of provision of pensions on a government's budget is often heavy and is the reason for political debates about the retirement age. The state might be interested in a later retirement age for economic reasons.

The cost of health care in retirement is large, because people tend to be ill more frequently in later life. Increasing numbers of older people, combined with an increase in the cost of healthcare, has led to the funding of post-retirement health care becoming a political issue. There is then pressure to reform healthcare systems to contain costs, or find new sources of funding.

Life after Retirement

Retirement might coincide with important life changes; a retired worker might move to a new location, for example a specialised retirement village, thereby having less frequent contact with their previous social context.

In some countries, retired workers will continue to participate in the life of their family and their society, often following ancient ethnic roles. Some countries are sponsoring initiatives to help retired workers keep contributing to social and cultural life.

Outside a retirement home

Many people in the later years of their lives, due to failing health, require assistance, the highest degree of assistance - in some countries - being provided in a nursing home. Those who need care, but are not in need of constant assistance, may choose to live in a retirement home. This is a facility giving the retired person some degree of freedom, yet with close-by medical assistance to handle emergencies.

Retirement ceases if the retiree decides to go back to work. Typically, retirees who go back to work are people who find the lack of activity boring and work mainly for their own amusement, often turning a hobby into a job. Old-age pensions are usually not reduced because of other income, so the latter comes on top of the former. This may be different in the case of a disability pension.

See also

• Pension
• AARP

External links

• The New Meaning of Retirement
• The CoolGrandma.com Online Community
• Retirement Lifestyles - hobbies, your grandkids, travel, and more
• Directory for Retirement Planning
• "Historical Development" Social Security Administration
• Songs For A Retirement Party
• The Retire Early Home Page
• Economic History of Retirement in the U.S. from EH.NET's Encyclopedia