What is a 401(k) Plan, How Does It Work, and Why Should I Be Participating in One Now? ©

By Mary Lou Savage, Senior Benefits Attorney, Association of Flight Attendants-CWA

WHAT IS A 401(K) PLAN?

A 401(k) plan is a kind of retirement plan known as a defined contribution plan (DC Plan). A DC Plan is also called an individual account plan..

A 410(k) Plan gets it name from section 401(k) of the Internal Revenue Code. That Code section states the general proposition that a profit-sharing or stock bonus plan … “shall not be considered as not satisfying the tax qualification requirements of subsection (a) merely because the plan includes a qualified cash or deferred arrangement.”
 
The qualified cash or deferred arrangement occurs when an employee elects to have the employer put part of the employee’s compensation into the employee account within the plan.
 
INDIVIDUAL ACCOUNTS
 
The individual account aspect of the Plan means that each employee has his or her own account, identified to his or her social security number, just like any other kind of investment account.
 
The compensation you defer and direct the company to deposit into your 401(k) account is yours from day one. There is never a vesting requirement for your own money.
 
The plan may have a vesting requirement -- that is, some period of time you have to work before the money is yours without any condition – for employer contributions or matching funds.
 
Once your money is in your account and you are vested in any employer contributions, no one can take that money. The creditors of the company, even in bankruptcy, have no claim to that money.
 
These accounts may be subject to qualified domestic relations orders to pay child support and other court determined payments. Otherwise, these accounts cannot be reached by your creditors.
 
INVESTMENT RISK

DC Plans place the investment risk on the employee account holder. This has an upside and a downside. The upside is that you get the benefit of any investment gains resulting from good investments and a strong stock market. The downside is that if you make poor investments or if the market is in a downturn, you will lose money in your account.
 
The name “defined contribution” plan means that the money going into the plan is known or calculable – your salary deferral amount and any employer contribution. The ultimate value of the account when you are ready to retire is not known.
 
What you will have in your 401(k) account for your retirement will depend on the amount you and your employer put in and how well you invest that money.
 
This is different from traditional pension plans, defined benefit plans, where the amount of the benefit is retirement is known, for example, $1200 a month for life, and the employer needs to contribute whatever amount of money is necessary to meet that obligation.
 
Unfortunately, other than social security, most employees now have only the proceeds of a DC Plan to support them in retirement.
 
This makes participation in your 401(k) plan critically important.
 
In addition to providing much needed money for retirement, participation in your 401(k) account protects your money from income tax, too!
 
Tax Benefits

There are a number of tax benefits to 401(k) Plan participation.
 
The first benefit is that the amount you put into your 401(k) is not subject to federal income tax now. The amount of your deferral is taken out before taxes are computed. That means that the federal government gives you a subsidy in the amount of your federal tax rate for each $100 you contribute.
 
If you contribute $1000 to your 401(k) and your federal income tax rate is 24%, you are saving $240 in federal income tax, in effect, the federal government is giving you $240 to put into your 401(k) account.
 
Many states piggyback on federal income tax amounts so you may save on your state taxes, too.
 
The second tax benefit is that your money grows tax free while it is in the 401(k) account. All the interest and monies earned from your investments are not subject to tax.
 
The first time this money is subject to tax is when you withdraw it after age 59.5. Generally, people are in a lower tax bracket when retired so there may be some taxes that are never collected on these monies.
 
Note, you can’t leave money in your 401(k) forever. You must start withdrawing a minimum amount by April after you are age 70.5.
 
CAVEAT – if you take money out of the account before age 59.5 or default on a 401(k) account loan, you will incur a 10% penalty in addition to having to pay regular income tax on that amount. Tax-favored accounts like 401(k) s have penalties when the money is taken out early.
 
These significant tax benefits are not available in other kinds of savings accounts, as important as other savings and investment account are as part of a complete financial and retirement savings program.
 
Contribution Limits

Because of the taxes lost when money is out into a 401(k) pan, the government limits the amount of money an employee can contribute to his or her account. For 2007, the limit on salary deferral is $15,500.
 
The total amount for all 401(k) plans you are in and from you and your employer is $45,000.
 
Anyone who puts more than these amounts in a 401(k) account will have to take it out and may also be subject to tax on those amounts.
 
Hardship Withdrawal

Depending on your plan, you may be eligible for a "hardship withdrawal," for those unexpected circumstances when you may need your money before retirement. According to IRS regulations, your "hardship" must represent an "immediate and heavy financial need" and there must not be "any other resources reasonably available to you to handle that financial need." The IRS recognizes four reasons for a hardship withdrawal:
Certain non-reimbursable medical expenses
Purchase of a primary residence
Payments of post-secondary tuition for the next yea
To prevent eviction from or foreclosure of the mortgage in your home.
Some plans also allow hardship withdrawals for other reasons. If so, you may need to show your employer proof of how you intend to use the money, and proof that the amount you requested isn't more than enough to satisfy your need. Certain hardship withdrawals will no longer be eligible for rollover. Therefore, there will no longer be 20 percent automatically withheld from your hardship amount, although it will still be subject to ordinary income taxes and a possible 10 percent early withdrawal penalty if you are under 59 1/2 (unless you qualify for an exception to this rule).
 

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