One of thehe most common employer-sponsored retirement plans, 401(k)s, are offered primarily by larger, for-profit companies with 10 or more employees, though tax-exempt organizations may also set up 401(k) plans. If your employer doesn’t offer a 401(k) retirement plan, you may still be eligible to open an IRA (Roth or traditional) through online brokers like TradeKing, optionsXpress, or the ever popular Scottrade.
How 401(k) Plans Work
401(k) plans allow you to contribute a certain amount of your paycheck each pay period into your own 401(k) retirement account. The amount of money that you contribute each period can be a set amount or a fixed percentage of your total annual pay. The investment options available to you in a 401(k) plan vary, based on:
- The selection of investments offered by the firm hired to administer the company’s 401(k) accounts
- The investments from that selection that your company chooses to offer employees
For instance, if your company uses Fidelity Investments to administer its 401(k) plan, its plans will offer only investments that Fidelity sells. The company might also choose to restrict that selection further by allowing you to invest 401(k) contributions exclusively in Fidelity mutual funds. In addition, your company may offer you an incentive to encourage you to invest a portion of your contributions in the company’s own stock.
Key Traits of 401(k) Retirement Plans
In most 401(k) plans, contributions are income tax–deductible and grow tax-deferred until withdrawal, when taxes become due. In some newer 401(k) plans, such as Roth 401(k)s, contributions are not tax-deductible but grow tax-free for life (see 401(k) Plan Variations).
Participation is voluntary and must be open to every employee age 21 or older. Most companies impose a waiting period—usually six months to a year—after which you can enroll in the plan.
Your contributions vest immediately. Your employer’s contributions typically vest over a set period of time.
Plan must be established on or before December 31. You can usually enroll at any time once you become eligible to participate.
Employer must make all contributions by its business tax filing date. Your contributions can be ongoing as long as you’re employed with the company.
Currently, you can contribute up to $17,000 ($22,500 if you’re age 50 or older). The total contributions to your plan (including both your contributions and your employer’s) cannot exceed $50,000 for 2012 ($55,500 per year if you’re age 50 or older). These limits typically increase each year in October.
Pretax or after-tax (Roth) payroll deductions (see 401(k) Plan Variations below).
A 10% penalty applies to withdrawals made prior to age 59 1/2. Exceptions include death, disability, or rollovers.
Most plans can be rolled over into other retirement plans.
Most 401(k) plans allow participants to borrow from their accounts.
Participants can designate primary and contingent beneficiaries.
Required minimum distributions
In most cases, participants must begin taking a minimum amount of annual distributions after age 70 1/2.
Fees and minimums
Typically, participants pay no annual fees. Minimums, if any, are determined by the employer.
401(k) Company Match and Profit Sharing
Companies may choose to include company match or profit sharing programs in their 401(k) plans to supplement their employees’ 401(k) contributions. Companies often use these features as a way to promote employee recruitment and retention.
- Company match: This option allows employers to match your 401(k) contributions each pay period, usually up to a fixed percentage. For instance, if you contribute 15% of your pretax pay to your 401(k) every pay period, your employer might match your contributions dollar-for-dollar up to 5%. Employer contributions have declined in recent years so be sure to ask and understand what your employer will contribute as well as the parameters of the plan.
- Profit sharing: In this option, your employer makes one large annual contribution to your 401(k) plan based on company profits (usually at the end of the calendar year), rather than smaller contributions each pay period.
The potential for you to benefit from both your own contributions and those of your employer is referred to as the double contribution benefit of 401(k) plans.
401(k) Plan Variations
Over the years, the government has developed many 401(k) plan variations to help companies tailor plans to their budget, organizational structure, and industry. The two most notable variants are Roth 401(k)s and solo 401(k)s.
Traditional 401(k) plan contributions use pretax dollars, are income tax–deductible, and grow tax-deferred until withdrawal. Roth 401(k) plan contributions use after-tax dollars and are not deductible, but are never taxed. Companies that offer Roth 401(k) plans allow you to divide your contributions between Roth and traditional 401(k) accounts.
Solo 401(k)s are designed to give sole proprietors (and their spouses) and some types of business partnerships the double contribution benefit of traditional 401(k)s. Solo 401(k)s offer higher annual contribution limits (relative to the participant’s income) than other small company plans, such as SEP and SIMPLE IRAs, and also permit after-tax Roth-style contributions.