What is a 401(k)?

Many of us have access to a 401(k) plan at our workplace – have you ever wondered exactly what a 401(k) is?

The 401(k) plan is named for a specific section in the Internal Revenue Code – Section 401, subsection k, to be exact.  This code section lays out the rules for these retirement plans, which are employer-sponsored plans providing a method for the worker or employee to defer a certain amount of income into a savings plan on a pre-tax basis.

Often the employer also includes a matching contribution to the employee’s account.  These matches are typically based upon the amount of contribution that the employee makes to the plan – such as a dollar-for-dollar match for contributions made by the employee up to certain percentage of the employee’s income.  The deferred income is not subject to ordinary income tax, but it is still subject to FICA (Social Security) and Medicare taxes.  The employer match is not subject to any of these taxes.

The income that the employee voluntarily defers into the 401(k) plan is immediately vested with the employee, meaning that the contributions that the employee makes belongs exclusively to the employee.  Employer-matching funds are usually subject to a schedule for vesting. An example would be that the employee must remain employed for a specific period of time (say, five years) before the employer-matching funds are vested with the employee.  Leaving employment prior to meeting that vesting schedule could result in the employee relinquishing a portion or all of the employer-matching funds in the account.

The income that is diverted into the 401(k) plan can be allocated to a variety of investment choices.  The choices are generally limited to a defined group of stocks and mutual funds by the plan administrator.  Lately many plans also offer an option to use a regular brokerage account to provide investment in virtually any domestic holding.

Restrictions

In addition to the restricted group of investments that you may have available to choose from, there are many other restrictions on your 401(k) account.  For example, once you divert your income into a 401(k) plan, you generally cannot withdraw the funds from the account while you’re still employed with that employer.  Some plans do have in-service distributions available after the employee has reached a particular age (generally 59½), but this is relatively rare.

After you leave employment you have the option of withdrawing the funds from the account.  There are a few ways that this can be done –

1. A direct rollover to another retirement plan (another 401(k) or an IRA), which is a non-taxable event; or
2. A cash distribution to you, which will be subject to a mandatory 20% withholding, since this is potentially a taxable event (even if you rollover the distribution to another plan within 60 days); or
3. A distribution of the securities that you own in the plan.  Part of this distribution may be taxable (see this article on NUA, Net Unrealized Appreciation, for more details).  The portion of the distribution that is taxable will be subject to the mandatory 20% withholding mentioned above.

If any of these distributions occurs before you reach age 59½ you may be subject to an early distribution penalty of 10% unless you meet one of the exceptions, which includes purchase of a first home and payment of certain medical expenses, among other exceptions.

Loans can be available to access the funds in your account while still employed.  The loans are limited to 50% of your total vested account balance, with a maximum loan amount of $50,000.  The loan must be paid back over the course of five years, at a prescribed rate of interest.  If you leave employment while your loan is still outstanding (at whatever amount), the loan must be paid back immediately, either from outside funds or from funds in the 401(k) account.  If the funds are paid back from within the 401(k), what happens is that you will be considered to have withdrawn the amount of the loan from the account, and the withdrawal will be subject to ordinary income tax and possibly a penalty if you are under age 59½ at the time you leave employment.

Contribution Limits

There are certain limits to the amount of contributions (income deferrals) that can be made into a 401(k) account.  For 2013, the annual limit for deferral of income is $17,500.  There is an additional “catch-up” contribution amount that folks over age 50 can make – up to $5,500.

There is also a maximum amount that can be contributed in total – including the employer match.  For 2013 this limit is $51,000, or $56,500 when the catch-up contribution is used.

All of these limits are based upon the employee’s salary, as well. If the employee’s salary is less than the annual maximum contribution limit, then the contributions are limited to 100% of the employee’s salary for the year.

Roth 401(k)

Briefly, there is another type of account that can be included in an employer’s 401(k) plan: the Roth 401(k), which is also known as a Designated Roth Account, or DRAC.  The DRAC allows the employee to divert income into the account on an after-tax basis – meaning that money contributed to the DRAC is taxed as if the employee received it in cash.  The funds in the DRAC account are subject to the same limitations of withdrawal (while employed) as the “regular” 401(k) account.  In return for the pre-payment of tax on these restricted funds, when the employee leaves employment he or she can access these funds tax-free once the employee reaches age 59½.

Wrap up

This article was not intended to cover every nuance of 401(k) plans; rather, it was intended to provide a brief overview of this important part of your retirement plan.  We’ll cover more specifics on the 401(k) plan in future articles.