401(K) BASICS
Bryan Baughman
Retirement plans come in many shapes and forms and each have their own distinguishing factors. The most popular type of plan used today is the 401(k) plan. Establishing a 401(k) plan has several benefits for both the company as well as its employees. A 401(k) plan can help attract and retain talented employees. Benefit packages, specifically 401(k) benefits, are carefully evaluated by employees when considering job opportunities. There are also tax advantages for the company as well as employees. This article will discuss several basic principles related to 401(k) plans. It is the first of a small series. Look for future articles that explore 401(k) plans in more detail.
The primary function of a 401(k) plan is to allow participants of the plan to save for their retirement. Participants contribute a portion of their salary to the plan, usually via payroll deduction. The participant’s money is invested until the participant retires and begins taking distributions.
401(k) plans were initially designed to allow plan participants to contribute to the plan with tax deferred contributions. Therefore, participants would not pay income taxes on the portion of their salary that is put into the plan until the participant retires and begins taking distributions from their plan balance. At the time distributions are taken, income taxes are paid on the original contributions as well earnings. In recent years, many employers have been including a Roth option in their 401(k) plan. Participants pay income taxes on their Roth contributions; however the contributions grow tax free. Therefore, no income tax is paid when the participant retires and begins taking distributions. Plans with a Roth option allow participants to have the option of choosing whether their contributions are taxed at retirement or taxed at the time they make the contribution.
401(k) plans can offer both participant directed and/or non-participant directed investments. Plans with participant directed investment options usually include a range of different mutual funds that allow participants to build a diverse portfolio. Many plans also include an investment option that allows participants to earn a fixed rate of return. The fixed rate investment option is usually in the form of a contract with an insurance company. This type of investment option has become very popular in recent years as participants seek to minimize their risk.
In addition to participants contributing a portion of their own salary into the plan, many employers also contribute money on behalf of their employees. Employer contributions can be in the form of a match or a discretionary contribution. A matching scenario would be the employer contributing to the plan, on behalf of the employee, the same amount that the employee contributes for themselves (up to a certain limit as defined by the employer). For example, the company matches employee contributions dollar for dollar, up to 3% of the participant’s compensation. Discretionary contributions allow the employer to decide on a set dollar amount to contribute to the plan that is allocated to all the participants proportionately. Either type of contribution made by the employer will generally result in a tax deduction on the company’s federal income tax return.
Some plans allow for participants to borrow money from their 401(k) account balance in the form of a loan. Participant loans are very similar to bank loans, except the participant is borrowing from their own plan balance. Participants sign a promissory note and repay the loan, plus interest, just as they would a traditional bank loan.
Every 401(k) plan will have a Plan Document that governs the operations of the plan. The design of the Plan Document is very important because it allows the IRS to determine that the plan is designed in an appropriate manner to qualify for the special tax treatment of plan dollars.
Saving for one’s retirement has never been more important than it is today. Life expectancies are increasing and the future availability of social security is uncertain. Establishing a 401(k) plan is a great way to provide a tremendous benefit to employees and the company alike. Please look for future articles that will explore the benefits and tax ramifications of 401(k) plans in more detail.
Bryan Baughman, CPA is an audit manager at PSK LLP, a forty six year old accounting firm in Arlington, TX. He has eight years of public accounting experience and works with construction and manufacturing companies. Bryan can be reached at 1-800-424-5790 or bryan@pskcpa.com. www.pskcpa.com