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Understanding your Company’s 401(k) Plan

Mary OstienJune 21, 2019

Group Benefits

In our February blog, we touched on the three components of retirement income: pensions, social security and savings.  So where does the 401(k) fall? Most people would place it in the pension column, but that would be incorrect. To determine why, it’s important to understand the difference between a pension and a 401(k).

Pensions are considered defined benefit plans because they guarantee a given amount of monthly income in retirement. The employer is responsible for the funding, investment and longevity risk associated with sponsoring a pension. So as you can imagine, as people started to live longer, the cost of maintaining pensions has escalated over time. As a result, many employers began to replace pensions with 401(k) plans.

The 401(k) plan was created in the Revenue Act of 1978, which included a provision to the Internal Revenue Code stating that an company could sponsor a defined contribution retirement plan and this is how it works. Unlike a pension, the employee is responsible for the funding and investing of the account, and there is no guarantee of a minimum or maximum benefit in retirement. Today, nearly 40 years since their inception, 401(k) plans are more common for retirees, comprising the largest amount of retirement assets.

So let’s look at the five key features of 401(k) plans:

  1. Eligibility and Enrollment
    • It is rare to be eligible for a 401(k) on the first day of work. Usually an employer will structure their plan to have some sort of “waiting period” before an employee is eligible to participate. This range can vary from as little as a couple of days up to 1 year, but once an employee becomes eligible, the enrollment is quite simple. Most employers provide hard copy enrollments forms where an eligible employee would complete a paper enrollment and beneficiary form. With the advancements in technology, many plan sponsors are moving to electronic enrollment via the computer and many providers now have smart phone “apps” where employees can enroll.
  2. Deferrals
    • For 2019, an employee can contribute up to $19,000 to a 401(k) Plan. These contributions are often referred to as “employee deferrals”. If the individual is over age 50, an additional $6,000 of contributions is allowed. This additional amount is known as a “catch-up” contribution. Thus, an employee over the age of 50 can defer $25,000 in tax year 2019. But before deciding how much to defer, employees might have to decide on which type of contribution to make, Traditional or Roth. Not all employers offer Roth contributions, but the Roth conduit has become more prevalent as employers try to make plans as attractive as possible. So what is the difference? Traditional contributions have been the norm since the beginning of 401(k) plans. The employee is allowed to have money withheld from their paycheck on a pre-tax basis and deposited into an account that grows tax-deferred until withdrawal. The concept of saving on taxes in your working years and paying them much later in your low-income retirement years makes sense. But the argument for Roth contributions was that the Tax Code was ever-changing, and no one could know whether tax rates would be higher or lower in the future. Therefore, why not offer a post-tax contribution, or “Roth” option? With Roth contributions, the taxes are paid now and then when the funds are taken out in retirement, the withdrawals are free from taxes.
  3. Employer contributions
    • This might be the biggest benefit of 401(k) plans. If you are fortunate, your employer contributes to your account. The employer may offer a matching contribution and/or a non-elective or profit-sharing contribution. This employer contribution is a great incentive for hiring and retaining quality talent. In addition, the company receives their own tax deduction for contributions. Like the eligibility requirements mentioned earlier, to receive the employer contribution, most employers have a service requirement before being eligible. To encourage loyalty and assist with retention, employers frequently make their contributions subject to vesting schedules. Vesting is a somewhat confusing concept since even though you might see the money in your account, you still could forfeit that money if you leave your job. If you leave prior to completing the vesting period, the funds revert to the company. This means the employer can dangle their contributions in front of you like a carrot — the more years you work, the more of their contributions you get to keep.
  4. Loans
    • Access to your money while you are employed and under the age of 59 ½ is not easy. Some plans offer an in-service withdrawal provision which allows the employee to access their account for any reason while employed, but the most likely option is via a loan. Loans allow an employee to borrow from their 401(k) account and pay the loan back through payroll reductions for a certain period of time (usually 5 years). The benefit of a loan is that it is not a taxable event as long as it is paid back in accordance with its terms. Also, the interest paid on the loan is credited back to the employees account. Finally, the process is simple. Because you are borrowing from yourself, you approve the loan. There is no documentation required like a traditional loan application process.
  5. Portability
    • At some point, an employee leaves their employer. As long as your new employer’s plan allows rollovers, you can move your current plan into your new employers plan in a tax-free transaction know as a “rollover.” If your new employer doesn’t have a plan or you are retiring, you can rollover your money into an IRA. Again, this is a non-taxable event, and allows the employee to have full control over their retirement savings. Another option is to leave you account right where it is. As long as you have a balance over $5,000, you are permitted to keep your account in your old employer plan; you can’t contribute and the employer will no longer contribute, but the account will remain open. The last option is taking a withdrawal. This is a taxable event and if the employee is under age 59 ½, there will be an additional 10% tax penalty.

If you have any questions about your 401(k), please give us a call at 610-651-2777 and we will help you find your answers.

 

Sources:

Investopedia.com – What is a Good 401k match?

Linkedin.com – How Many Jobs will the Average Person have in his or her Lifetime?