This is an employer sponsored retirement plan that is eligible to employees where they can make salary reduction contributions on a pre-tax or post-tax basis. The 401k plan allows employees to save and invest part of the income before taxes are deducted.
Employers who offer the plan to their employees can choose to match individual contributions to the plan on behalf of their employee. A profit sharing feature may also be added to the plan. What you need to know is that taxes are not paid until the money is withdrawn from the account.
The 401k plan was enacted into law in 1978 and its purpose was to enable taxpayers break on taxes on deferred income. Ted Benna, a benefits consultant studied the plan and found that a simple tax advantaged method could be created to allow employees save for retirement. This was in 1980.
The client he was working for decided not to create a 401k plan which prompted him to set up the first 401k plan with his own employer. During this time, employees had the opportunity of contributing 25% of their salary which accounted for up to $30,000 annually to their employer’s 401k plan.
Thanks to the benefits that were offered by the plan, employers adopted it and continued to enroll their employees.
How It Works
As said earlier, only employers are allowed to sponsor 401k plans for their employees. As the employee, you have the power to decide how much money is deducted from your paycheck.
The amount deducted is deposited in the plan based on limits imposed by the IRS and the plan. Employers have the choice of contributing to their employees plan but this is optional.
The employer has the responsibility of running the plan in accordance with the rules and regulations plus the provisions of the plan. These rules and regulations help to indicate who is eligible for the plan, how much is to be contributed and when the contributions are made.
Furthermore, they help to indicate how much the employer can contribute, what investment options are available and features of the plan among others.
While the employer has the responsibility of running the 401k plan, they do hire administrators who can include mutual fund companies, a brokerage firm or an insurance company.
What happens is that your employer sends contributions directly to the administrator. From here, you are responsible for selecting which investment vehicles you want to invest in.
401(k) Withdrawal rules
It is important to note that early withdrawals from the 401k plan receive a 10% early withdrawal penalty by the IRS. For this to happen, the employee must be aged 59 ½ years and below. It is permitted for the employee to take a hardship withdrawal. The funds can be used to cover the following:
a. Medical expenses for the employee, spouse or dependent
b. Costs associated with the purchase of a home
c. Payment of certain college expenses
d. Costs that prevent your eviction or foreclosure on your principal residence
e. Costs associated with repairs to your principal residence.
To qualify for the above, an employee must show their employer financial proof that the funds are needed to be withdrawn early from the 401(k) plan.
An alternative to the above is to self certify which means the employee will not have the need to disclose his or her finances. Once the withdrawal is made, no new contributions will be made to the 401k for 6 months.
Once you attain the age of 70 ½ years, the government requires you to start withdrawing the funds without any penalty. The reason for this is that the government wants to earn revenue after allowing you to defer paying taxes on your contributions and growth.
This means that starting April 1 of every year, you will be required to take regular distributions.
The good news is that you will receive the required distributions based on your life expectancy. Remember, penalties do apply if you miss on taking the minimum distribution or take the wrong amount.