401K- Is it Really Worth in the Current Setting?
Retirement Plan for US residents
The 401(k) plan is an employer-sponsored retirement plan that residents of the United States can avail of. It derived its name from the 1978 Internal Revenue Code. 401(k) allows one to save money for retirement. The retirement savings plan in 401 (k) is paid for by the employee and more often than not with additional matching contribution from the employer. The perceived advantages of 401 (k) plan is the fact that the contributions and the resulting income it earns are tax-free until withdrawn mostly upon retirement. Income taxes on the money save is applicable upon withdrawal of the savings.
The Internal Revenue Service (IRS) makes the guidelines for the 401(k) plan but it is the Employee Benefits Security Administration of the U.S. Department of Labor that implements it. Section 401 (a) of the US Tax Code defines qualified plan trusts and enumerates the rules required for qualification. Section 401 (k) specifies for an optional "cash or deferred" way of receiving contributions from employees.
Since it is part of the benefits employees enjoy, 401(k) is paid by the employers often in private company. Self-employed individuals can apply for 401(k) plan. In 1986, government offices were allowed to avail of the said opportunity as well. The employer serves as the trustee for the 401(k) plan. His functions are manifold: set up and design the plan; select and check the progress of the plan investments. Employers though have the option to designate outsourcing agencies such as bank, mutual funds, and third party administrator or insurance companies to do all the tasks for him.
Employees have the option to set aside part of the wage to be paid for the 401(k) account. There are two ways of setting up the 401(k) plans: trustee-directed and the participant-directed plans. The former enables employers to designate trustees or fiduciaries who will determine how the assets will be invested. The most popular option though is participant-directed plans where employees can choose how the money will be invested. Investment options open to employees include mutual funds of stocks, bonds, money market investments or a combination of all. A number of 401(k) plans allow the purchase of company’s stock. The employee can make investment choices any time they want to.
401(k) plan is profit sharing plan that offers qualified Cash or Deferred Arrangement. The contributions are made voluntarily and the benefits are not as defined as pension plans. They fall under individual account plans because the participant’s benefit equals the value of the individual account.
Some employers provide incentive to their employees by paying additional contributions to the employee’s account which they could save for retirement. Employers can also choose to make profit sharing contributions directly to the 401(k) plan. Some employers based their contribution as a fixed percentage of the employees’ wages. The contributions are intended to persuade the employee to stay longer with the employer.
The good thing with 401(k) plan is once the employee stops working, 401(k) remains active throughout the employee’s life but the savings can be withdrawn when he reaches the age of 70 ½.
Back in 2004, companies began requiring ex-employees to pay a fee if they want to maintain their 401(k) account with the former company. The employee has the option of moving their 401 (K) account to the IRA using independent financial establishment like banks. Another option would be to move the 401 (K) account from the former employer to be hosted by the new employer.
By 2006, employees can choose the Roth 401(k), Roth 403(b) in place of the Roth IRA. But the plan sponsor is required to change the plan to allow this kind of option.
As mentioned earlier, the employee is not required to pay federal income tax based on the amount the person defers. For instance, an employee who earns $50,000 a year and contributes $3,000 to 401(k) account that year only reports $47,000 as his/her income on the tax return for the year. The savings would equal to $750 in taxes for the individual in 2004 using the 25% marginal tax bracket with no additional deductions.
The earnings such as interest, dividends or capital gains derived from the 401 (k) investments are not taxable also. This would redound to additional compound tax benefits for the 401(k) account holder.
Taxes are paid upon the withdrawal of funds from 401(k). This usually happens during retirement. Tax is imposed because gains become “ordinary income” when the money is withdrawn. Often people hold the misconception that in 401 (k) it is more advantageous to belong to the lower tax bracket in retirement than working years. But this is not so because tax imposed on ordinary income could reach as high as 35% as compared to the capital gain rate of only 15%.
It is hard to withdraw from 401(k) savings while still working especially if the employee is below 59 ½ years of age. Withdrawals done before reaching 59 ½ needs to pay excise tax of ten percent of the amount except if the reason for early withdrawal is hardship. In order to qualify for hardship the tax code requires the following circumstances to manifest:
Paying for a primary residence (mortgage payments are not included)
- To prevent foreclosure of or eviction from primary residence
- Payment of secondary education expenses incurred in the last 12 months for the employee, his/her spouse, or dependent(s)
- Medical expenses not covered by insurance for employee, their spouse, or dependent(s) which would be deductible on a federal tax return (i.e. non-essential cosmetic surgery would not be acceptable)
- Funeral expenses for the employee's deceased parent(s), spouse, child(ren), or dependent(s) (as of December 31, 2005)
- Home repairs due to a deductible casualty loss (as of December 31, 2005)
For other reasons, the amount is treated as ordinary income. Employers have the option to reject one or all the aforementioned hardship causes. In such cases, the employee has the option to resign from work.
Tax benefits from the income saved in the 401(k) plan are protected by law through the restrictions it imposed on withdrawal of funds. The law requires that as much as possible the money should remain in the 401 (k) plan or similar tax deferred plan until the employee turns 59 ½ years old. Of course, the abovementioned exceptions will be considered.
To ensure that the money would not be withdrawn before the employee turns 59 ½ years, a 10% penalty tax is meted unless exceptions apply. Aside from the penalty tax, the employee has to pay tax for “ordinary income” upon withdrawal. The 10% penalty tax will not be required if the following conditions or situations exist;
- Death of the employee
- Total and permanent disability of the employee
- End of service during or after reaching 55 years of age
- Significant equal periodic payments stipulated under section 72(t)
- Qualified domestic relations order
- Deductible medical expenses ( more than the 7.5% minimum)
A number of 401 (k) plans also permit employees to loan from their 401 (k) which is to be paid using the after-tax funds and with pre-determined interest rates. The proceeds from the interest forms part of the 401 (k) balance. The loan is not taxable as long as it is paid back within the stipulations contained in section 72 (p) of the Internal Revenue Code. This section requires that:
- the loan be for a term not more than 5 years (except when used to purchase primary residence),
- that a "reasonable" interest rate be charged,
- that significant equal payments (to be made least every quarter) be made over the life of the loan.
401(k) plans have several distinct advantages. These are:
· it reduces the amount of tax money the employee has to pay because the amount used to pay 401(k) is pre-tax money
· all employer contributions and any interest incurred are tax-free until withdrawal. The compounding effect derived from this tax exemption could amount to huge savings.
· the employee has the option to choose investments for his/her contributions
· if the amount contributed by the employee to 401 (k) is matched by the company total salary would come out higher
· unlike pension plan, all contributions in 401 (k) can be “rolled over” from old employer to new employer’s plan (or to an IRA) if the employee changes jobs.
· since the program is a personal investment program for retirement, it is protected by pension (ERISA) laws. This protects the funds from creditors or being assigned to another person except in domestic relations court cases such as divorce decree or child support orders (QDROs; i.e., qualified domestic relations orders).
· while the 401(k) is similar in nature to an IRA, it has more advantages than IRA due to the matching company contributions. Also, personal IRA contributions are subject to much lower limits.
Just as there are advantages, there are also some perceived disadvantages of the 401(k) plans. These are:
· it is difficult to access 401(k) savings before age 59 1/2 except for few exceptional cases.
· 401(k) plans are not insured by the Pension Benefit Guaranty Corporation (PBGC).
· employer matching contributions are usually not vested (such as do not become the property of the employee) until several years have passed. Employer matching contributions are vested according to one of two schedules, either a 3-year "cliff" plan (100% after 3 years) or a 6-year "graded" plan (20% per year in years 2 through 6) as per rule.