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What is a 401(k)?

Most large employers now offer their employees a 401(k) retirement plan, sometimes called a "salary-reduction" plan. Typically, the employer sets up the plan with an investment company, an insurance company or a bank trust department. You, the employee, agree to put part of your salary into a special savings and investment account. Most 401(k) plans offer a variety of investment vehicles, from individual stocks or mutual funds to money market accounts. Importantly, the money you invest isn’t counted as income when you complete your annual tax return. For example, if you earn $35,000 but put $5,000 into a 401(k), your taxable income for the year would be only $30,000. Earnings that accumulate in the account are not taxed until you start making withdrawals, usually after you reach age 59 1/2. If you withdraw earlier, you’ll have to pay taxes on the money and a stiff 10 percent penalty. Most companies that offer 401(k) plans also match employee contributions. For example, the company might add 50 cents to the account for every dollar contributed by the employee. That makes a 401(k) plan a much better vehicle for retirement savings than an individual retirement account, which does not involve a matching contribution from your employer.

How did 401(k)s get their name?

The popular 401(k) retirement plan draws its name from the Section 401 of the Internal Revenue Code. Other popular plans such as the 403(b) or 457 also draw their names from this same Code.

How is a 401(k) different from a regular pension?

The biggest difference between a 401(k) and a "regular pension" is that a 401(k) gives you much more control over your retirement nest egg. A 401(k) is funded with your own money and, in some cases, by a contribution from your employer as well. You decide how much to save and how to invest. A traditional, "regular" pension is funded and controlled by your employer.There are two types of pension plans: defined contribution (where the employer contributes a percentage of compensation determined by the formula in the plan document)and defined benefit. A "defined benefit plan" promises to pay you a specific monthly income in retirement -- in other words, a defined benefit. What you get when you retire will be based on your salary and the number of years you worked for the company. The company must put aside enough money each year to fulfill this promise but occasionally -- as some workers have unfortunately discovered -- it’s a promise that the employer may not be able to keep. Sometimes employers go bankrupt.
Most pension plans are covered by the Pension Benefit Guarantee Corp., which guarantees benefits to workers even if a firm is liquidated in bankruptcy. There are some plans that are not covered, however, such as those offered by professional service firms (such as doctors and lawyers) with fewer than 26 employees, by church groups or by federal, state or local governments.

How is a 401(k) different from a profit-sharing plan?

Technically, 401(k) plans are considered profit-sharing plans. But on a practical level, they’re usually different in several ways from the classic profit-sharing plan. In a profit-sharing plan, the employer makes contributions for eligible employees whether or not they also contribute to the plan. However, In a 401(k) plan eligible employees can choose to participate or not. If they choose to participate, they make their contributions pre-tax through a salary deferral agreement with the employer. Their deferral may or may not be matched by the employer. Since it is a type of profit sharing plan the employer can also make profit sharing contributions to the plan. These contributions (also called non-elective contributions) are allocated to all eligible employees whether they contribute to the plan through deferrals or not.

How long do I have to wait after being hired to join the 401(k) plan?

Some companies allow workers to join their 401(k) plans immediately. But other companies utilize a federal law that allows firms to wait until a worker has logged at least one year of service before joining the plan. The reason: Many employees quit before their first year is up, and companies want to avoid the administrative costs involved in setting up a 401(k) for a worker who might not stay very long. A company is also allowed to exclude anyone under the age of 21. In part, that’s because younger employees often don’t take advantage of the plans even when they are eligible (even though they should). If younger workers are eligible to join the plan but don’t, their lower participation rate can reduce the amount that other employees are permitted to contribute because of federal rules.

What happens to the money I put into the 401(k) plan?

The money you put into a 401(k) plan is invested according to the choices you’ve made from a list of options offered by your employer. These options typically include stock and bond mutual funds, money market funds, a guaranteed investment contract (GIC) that pays a fixed interest rate and your company’s stock.

What information about my 401(k) plan am I legally entitled to have?

The federal government requires companies to provide only minimal information to workers who take part in a 401(k) plan. Technically, all you’re entitled to is a summary of how the plan works, a summary annual report and an annual statement. If the plan allows you to invest in the company’s stock, you are also entitled to receive a prospectus or similar document. Fortunately, many companies provide far more, and you can also do your own research. For example, if a mutual fund is offered in your 401(k), you’re free to contact the fund directly and ask for its performance history and other pertinent information. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), federal disclosure requirements are so minimal "because 401(k) plans are governed by a law that was written before they existed-the 1974 Employee Retirement Income Security Act, better known as ERISA. ERISA didn’t anticipate pension plans in which employees would make most of the investment decisions; consequently, its disclosure rules are relatively undemanding. But don’t worry, you probably won’t have any difficulty getting much more information than ERISA requires. Employers are strongly motivated to provide employees with all the information they need to use the plan wisely."

What recourse do I have if my employer and I disagree about my 401(k) account?

Most questions or problems concerning a 401(k) can be cleared up quickly and amicably with a phone call or a letter. But major disagreements must usually be solved through a more formal process. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "Your employer is required by law to include a claims review process in which you can file a written claim with the plan administrator. That’s the person or committee responsible for handling the day-to-day administration of the plan. The plan administrator must respond to participant questions and give an explanation for any denial of benefits. If you don’t find the explanation acceptable, you can request a review of the matter. If you’re still not satisfied, you should seek outside support from an attorney and/or the Department of Labor."

How do I know how well my 401(k) investments are doing?

If you have invested in a 401(k) retirement plan, it’s important to stay abreast of how your investment is faring. At a minimum, the company that administers your plan will provide an annual statement that shows the amounts you have contributed and how those investments have performed. Many plans report on a semi-annual or quarterly basis, and some even issue monthly updates. Of course, you can probably get a pretty good handle on how your 401(k) retirement portfolio is doing on a daily or weekly basis by checking the business section of your local newspaper or by reading publications such as The Wall Street Journal or Barron’s. If the bulk of your portfolio is in mutual funds or your company’s stock, for instance, those publications can tell you how much their value has changed over the course of a given day or week.

Do employers guarantee 401(k) accounts?

Employers never guarantee 401(k) accounts. They are instead considered "fiduciaries" of 401(k) plans, which means they are legally responsible for supervising-not guaranteeing-the money you invest. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), this supervisory relationship obligates the employer "to protect your financial interests by choosing reputable and competent plan trustees, administrators and investment managers and continuously monitoring their performance of their duties. If employers choose to follow the voluntary 404(c) regulations established by the Department of Labor, they must give plan participants at least three distinctly different investment choices, each of which has a different level of risk. You must also be given the opportunity to move your money among these investments at least quarterly, and sufficient information to make sensible, informed investment decisions. But your employer doesn’t offer you protection against any investment losses you may suffer."

Does the government guarantee my 401(k) account?

Although most traditional pension plans are insured by the federal government, there is no such guarantee for 401(k) accounts. Traditional pension plans are insured by the federal Pension Benefit Guaranty Corp. because the government wants to ensure that the payments a company promises its retirees will indeed be made. But 401(k)s do not involve a promise of future benefits. The value of your account will rise and fall over the course of the years, and you could theoretically be wiped out if your investments perform badly. If it helps you sleep better, you may want to know that one of the duties of the federal Pension and Welfare Benefits Administration is to ensure that all employers and 401(k) trustees follow government requirements. That’s not as good as a guarantee, but it’s better than nothing.

What happens to my 401(k) account when I retire?

If you have a 401(k) and retire, you will likely have four choices(assuming you are over 59 1/2). According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), those choices will be: 1. Taking the money in a lump sum. If you do, you’ll owe income taxes on all of it. The disadvantage is that after you’ve taken the lump-sum distribution, your money is no longer in a tax-deferred retirement account. That means that the only way to avoid tax on any future earnings is to invest it in tax-exempt instruments. 2. Rolling your entire balance into an IRA. Then you can take out money as you need it, paying income taxes only on the amount you withdraw. This gives you more flexibility than any other option. Most of your money will continue to be sheltered in a tax-deferred account. You’ll have a nearly unlimited choice of investments, too. 3. Taking a 401(k) payout as a lifetime annuity. Not all plans offer this. An annuity pays a monthly benefit for your lifetime alone or, if you choose a joint-and-survivor annuity, for your lifetime and your spouse’s. The advantage of an annuity is that it provides a guaranteed lifetime benefit. The disadvantage is that, because it’s a fixed amount, its purchasing power will be reduced every year by inflation. 4. Leaving some or all of the money in your 401(k). You must have at least $5,000 in your account to do this. This choice makes little sense, however, since, if you like the investments available in the plan, you can use those same investments in your own IRA and completely control you access to your money. If you leave it with the plan, you’ll need to comply with the plan administrator’s rules and proceedures for making withdrawals or changing investments.

What happens to my 401(k) account when I die?

One of the first things you are supposed to do when you join a 401(k) is to designate a beneficiary who will receive the money in your account when you die. If you somehow failed to designate a beneficiary, your estate will automatically become the beneficiary. If your beneficiary is your spouse, he or she will have most of the same options with the money that you would have if you were leaving the company to take another job. Your spouse could roll the money over into an Individual Retirement Account (IRA), or withdraw it all and pay income taxes on it. If your spouse decides to roll the money over into an IRA, the rollover should be direct from the employer to the IRA account. This prevents deduction of any withholding tax. If your survivor decides to withdraw the cash and pay the taxes, the Internal Revenue Service will waive its early withdrawal penalty regardless of the spouse’s age. Importantly, though, your spouse will probably not have the right to keep the money invested in the same 401(k) plan. Even more restrictions would be placed on your beneficiary if the beneficiary is not your spouse. For example, the beneficiary couldn’t roll the money over into an IRA. Most plans provide for full vesting when you die, so any matching contributions made by your employer would likely be included in the distribution to your beneficiary.

What happens to my 401(k) account if I’m disabled?

If you are completely disabled and cannot work, you can tap your 401(k) plan without being charged a 10 percent penalty regardless of your age. However, you will owe ordinary income taxes on the money you withdraw. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you’re disabled, you may also be able to take out any matching contributions your employer made even if you haven’t completed the years of service normally required for vesting. Most plans provide for full vesting whenever a participant becomes disabled. But each plan has its own definition of what’s required to qualify for disability. Ask your human resources or personnel department about your plan’s rules. "If your plan does provide full vesting for disabled employees and your employment is terminated as a result of a qualifying disability, you’ll receive your vested account balance-your contributions and your employer’s contributions and what they earned. If your plan doesn’t have a disability feature, or if you don’t meet the plan’s definition of disability, your distributions from the plan will be processed the same as those of other former employees."

Does participating in a 401(k) affect any of my other benefits?

Participating in a 401(k) plan probably won’t affect any of the other benefits your employer offers, as long as you make sure the amount you contribute is added back to your salary for the purpose of calculating those other benefits. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "If you earn $40,000 a year, for example, and contribute $2,000 to the 401(k) plan, your taxable income is reduced to $38,000. That means that if your group life insurance covers you for twice your salary, you’ll have only $76,000 of coverage-unless the 401(k) contribution is included in the calculation. Talk to your human resources or personnel department about it."

Why are the dividends on the employee stock portion of my 401(k) plan paid out to me instead of being reinvested?

Corporations often pay out the dividends on the employee stock portion of their 401(k) plans because doing so can provide the companies with an important tax break. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Under the Internal Revenue Code, dividends paid on employer stock held in a 401(k) plan are fully deductible to the corporation if paid directly to the employee and are fully taxable to the employee. Therefore, the corporation may want to take this option to get a current year tax deduction."

How can having a 401(k) help my child qualify for financial aid?

One commonly overlooked benefit of making the maximum annual contribution to a 401(k) retirement plan is that it can boost your child’s chances of getting financial aid when it’s time to go off to college. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver), "Increasing your 401(k) contributions to the maximum level might make it easier to qualify for financial aid because these balances are excluded from most college-aid calculations and reduce your taxable income at the same time. Earnings within such plans accumulate on a tax-deferred basis and may be borrowed under certain exacting standards for your children’s education. Interest that you pay back to your account is not tax-deductible, but does accrue to your account balance. You should make sure your plan allows borrowing if you consider this alternative." Before you take this approach you should check out your plan’s loan rules. Some plans don’t allow loans, and some plans have very restrictive provisions that may invalidate this idea.

If I’m saving money that I plan to use before I retire, does it make sense to do it with after-tax 401(k) contributions?

If you’re saving money that you plan to use before you retire, it’s usually better to save it outside your 401(k) plan. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "It’s true that usually you can withdraw your after-tax 401(k) contributions at any time without taxes or penalty, but remember, you’ll owe taxes on any interest they earned, as well as a 10% early withdrawal penalty if you’re under age 59 1/2. The 10% penalty is an expense you wouldn’t have if you saved on an after-tax basis outside your 401(k) plan. "But there are situations where it can make sense to use after-tax contributions for short-term savings: if your employer matches your after-tax contributions and if you’re fully vested in the matching contributions by the time you withdraw the money, you may wind up with more money by saving in the 401(k) plan, even after taking the 10% early withdrawal penalty into account."

Are the assets in my 401(k) plan exempt from creditors in a bankruptcy?

The U.S. Supreme Court has held that savings in a qualified retirement plan, such as a 401(k) or IRA, are exempt from creditor claims in a bankruptcy. However, some courts have allowed the IRS to invade plan assets to recoup amounts owed by the plan participant. In fact, ERISA (the comprehensive pension law enacted in 1974) does not protect plan assets from IRS claims against a participant’s qualified plan or IRA account.

Can I invest in both my company’s 401(k) plan and an Individual Retirement Account?

You can invest in a 401(k) plan and an Individual Retirement Account (IRA). However, depending on your salary, the money you contribute to your IRA might not be tax-deductible. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), under current law, if you participate in a qualified employer-sponsored pension plan like a 401(k), you can only deduct a $2,000 annual IRA contribution if you are single and earn less than $33,000 in 2001or are a married joint filer with a combined income of less than $53,000 in 2001. You qualify for a partial deduction on the IRA contribution in 2001 if you are single and earn between $33,000 and $43,000, or if you are a married joint filer and your combined income is between $53,000 and $63,000. Consult with your tax advisor to determine the exact deductible amount. Of course, even if you make a non-deductible IRA contribution, its earnings won’t be taxed until the money is withdrawn.

If I decide not to participate in my 401(k) plan, will I be eligible for a fully deductible IRA?

If you decide not to participate in a 401(k) plan that’s offered by your employer, you are still eligible for a fully deductible Individual Retirement Account (IRA) regardless of your salary as long as you do not actively participate in any qualified plan. If your spouse is an active participant and your combined AGI is$160,000 or more you cannot deduct your IRA contribution, even if you are not an active participant. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "You’re automatically considered an active participant in a pension plan if you’re eligible for a defined benefit plan-the traditional pension that’s fully funded by the employer. But in a defined contribution plan like a 401(k), you’re not considered an active participant unless you elect to contribute to the plan, your employer contributes to it on your behalf or your account is allocated part of the forfeitures (the nonvested part of someone’s account who terminates employment). "There’s a very simple way to determine whether or not you’re an active participant in a pension plan: every January or February your employer sends you a W-2 form-the form stating your wages for the year just ended. Take a look at Box 15 on the W-2 form. If there’s no X in that box, you don’t actively participate in a pension plan and the IRS won’t challenge you for taking a deduction for an IRA contribution."

If I have to choose between a 401(k) and IRA, which choice makes more sense?

If you have to choose between participating in a 401(k) or contributing to an Individual Retirement Account (IRA), a 401(k) is almost always the best choice. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "This decision is truly a no-brainer if your IRA contributions aren’t tax deductible and/or your employer provides a matching contribution to your 401(k) plan. A 401(k) with an employer’s match is a much better deal than an IRA that has no matching contribution and won’t reduce your current income tax bill. In fact, unless you’re uncomfortable with the 401(k) plan’s investment options, it’s a better deal even if you don’t have an employer match and your IRA contributions are fully tax-deductible. The reason: depending on your salary, a 401(k) plan may let you save up to $10,500 in the 2001 tax year. Your maximum annual IRA contribution is limited to $2,000. It’s also easier to save in a 401(k) plan than in an IRA and for a very simple reason: your 401(k) contributions are taken out of your paycheck automatically. Saving in an IRA requires a continuing conscious decision and self-discipline that many of us don’t have. Another important potential advantage 401(k)s have over IRAs is that many 401(k) plans allow loans." Still, choosing an IRA would provide at least one distinct advantage over a 401(k): Withdrawals would be much easier. You can’t withdraw money from a 401(k) plan before you reach retirement or terminate unless you qualify for an Internal Revenue Service-approved financial hardship claim or can access a plan loan. Such rules don’t apply to IRAs. However, an early withdrawal from an IRA would still be subject to a 10% penalty as well as income taxes.

An IRA seems safer than a 401(k) plan. Can I switch my money from my 401(k) into an IRA?

An Individual Retirement Account (IRA) isn’t really any safer than a 401(k) plan. In addition, a 401(k) plan provides several benefits that IRAs do not. You can usually contribute an amount that’s much higher than the $2,000 a year you can put in an IRA. Your 401(k) contribution also reduces your current taxes. Depending on what you earn, an IRA contribution might not do that. That said, the only way you can switch money from your 401(k) into an IRA is if you are getting a 401(k) distribution. That won’t happen unless you are leaving your job.

When I change jobs, how do I decide whether to leave my money in the company plan or switch it to an IRA?

If you have been participating in a company-sponsored retirement plan and decide to change jobs and you have at least $5,000, you can usually either leave your money in the company plan or roll it over into an Individual Retirement Account (IRA). Each choice has its advantages and disadvantages. According to "Wealth Enhancement & Preservation" (The Institute Inc., Denver, Colo.), "By moving former plan funds to an IRA, you are taking on the full responsibility of investing your funds -- or at least the responsibility of choosing money managers and monitoring their performance. You must also consider security. An IRA does not always enjoy the protection against creditors that is implicit in a qualified plan’s ERISA protection. State law defines the creditor protection given to IRAs. "Many retirees elect to roll over their work-sponsored plans to increase their flexibility in investment choices. Their concerns include control over plan amendments, the necessity to deal with company pension departments which may be located outside the state where they reside and the loss of direct communication with the company because of retirement." When faced with the decision "to roll or not to roll," your best bet is to meet with a financial planner who will help you clarify your objectives and guide you through the complexities of making this important investment decision. The more you know about your alternatives, the more comfortable you will be with your final decision.

Is there a dollar limit on how much 401(k) money I can transfer to an IRA?

There’s no dollar limit on the amount of money you can have transferred from a 401(k) plan to a rollover individual retirement account. You can roll your entire 401(k) balance into the IRA, provided it contains no after-tax contributions. If your 401(k) contains some after-tax contributions, you’ll have to take those contributions as a distribution. However, since you have already paid taxes on the money, you won’t have to pay taxes on them again. Good news! After 2001, the new Economic Growth and Tax Relief Reconciliation Act of 2001(EGTRR 2001) will allow you roll over the after-tax contributions also.

If I roll my 401(k) money into a rollover IRA, what are the distribution requirements?

If you roll your 401(k) money into a traditional Individual Retirement Account, you will have to start taking money out of the rollover IRA no later than April 1 of the year after you turn 70 1/2. In other words, if you turned 70 1/2 in 2001, you would have to take your first distribution by April 1, 2002. However,this rule will not apply to your employer sponsored retirement plan accounts if you are still employed and do not own more than 5% of the company. IRAs must begin distribution even if your are not retired. (Rolling over into a Roth IRA requires you to pay taxes on the amount that you roll over, but there are no deadlines for taking distributions.)
The minimum you will have to withdraw depends on your life expectancy, which is determined by life expectancy tables published by the Internal Revenue Service. However, you can use the tables in one of two ways: You can calculate your minimum required distribution by dividing your account balance by the number of years remaining in your life expectancy, or by using your joint life expectancy with your spouse.
According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "It’s worth doing the calculation both ways to see which is better for you. You come up with very different mandatory withdrawal amounts depending on whether you use one life expectancy or two. You must pay taxes on these mandatory distributions; you can’t roll them into an IRA."

Why is it important to transfer money directly from a 401(k) account to a rollover IRA?

According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "There’s a very important difference between a rollover or "conduit" IRA and a regular IRA: A rollover IRA contains only money that originally came from a 401(k) plan, or other qualified pension plan. By keeping money from your 401(k) in a separate rollover IRA instead of in a regular IRA, you preserve your legal right to transfer it into another 401(k) plan at a future date. That’s important because money you have in a 401(k) plan may be available for loans. IRA money can never be borrowed. Don’t make additional contributions to your conduit IRA in the future or you lose the right to roll it back into a 401(k) plan. You can always save money in a regular IRA instead."

Can't I just have a check made out to me for the amount of my 401(k), and then deposit it in a rollover IRA within 60 days?

If you leave your job and decide that you don't want to leave your 401(k) plan there, the best and easiest way to transfer the money is to have the proceeds transferred into a rollover Individual Retirement Account (IRA). Many stock brokerage firms, mutual fund companies and other financial institutions offer rollover accounts and will handle nearly all of the paper work for you. The trustee of your old 401(k) plan will simply write out a check payable to the trustee of the rollover IRA. Technically, you can have your old employer's 401(k) plan deliver a check directly to you and still have up to 60 days to deposit the money in a rollover IRA. But if you do, your 401(k) distribution will be subject to a mandatory 20% withholding tax. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), "This means that if your 401(k) account is worth $100,000, you'll get a check for $80,000. The tax is withheld just in case you change your mind about opening that IRA account. If you really do deposit $100,000 in an IRA within sixty days, then the $20,000 that was withheld will be refunded to you by April or May of the following year. "But in the meantime, you face a classic Catch-22 dilemma. How can you deposit $100,000, when all you received from your 401(k) plan is $80,000? Unless you happen to have a spare $20,000 lying around that you can add to your IRA deposit, you're going to be taxed exactly as if you had taken a $20,000 withdrawal. In other words, if you deposit only the $80,000 you received in the IRA, the government will add $20,000 to your taxable income for the year. The upshot is that you don't get a $20,000 refund. If you're in the 28% bracket, you get back only $14,400. If you're under age 59 1/2, you'll also owe a 10% early withdrawal penalty, so you get back only $12,400." The bottom line: If you're leaving your job, don't do anything with the money in your 401(k) plan until you have opened a rollover IRA. Then have your 401(k) plan administrator do a direct, trustee-to-trustee transfer into your new account.

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