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A 401(k) plan is an employee-funded and employer-sponsored retirement plan. This type of plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. In some cases, employers can opt to match the employees' contribution. The amount the participant receives in retirement is based on the amount contributed to the plan and investment returns on those contributions.

Eligibility

The eligibility requirements for a 401(k) plan is set by the employer; some allow immediate enrollment on joining the company, while others require a 3-12 month waiting period.

Contributions

The employee elects to have a portion of their paycheck paid directly into their 401(k) account. These contributions are made before taxes, allowing for tax deferral. Some companies offer to contribute an additional amount based on the amount the employee contributes (often 25%, 50% or even 100%). Any additional amounts matched by the company or investment earnings are also tax-deferred until retirement. The contribution or deferred limits of a 401(k) plan are currently $12,000 or up to 20-25% of the employee's pre-tax salary.

Investment Options

In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, money market investments, bonds, or some mix of the above. Since this account is held until retirement, a more aggressive approach can be taken toward the 401(k) investments.

Many companies' 401(k) plans also offer the option to purchase the company's stock. However, it's not necessarily a good idea for the participant to put too much money in the company's stock since they are already dependent on the company for their job, thus compounding their risks.

The employee can generally re-allocate money among these investment choices; some plans will allow daily changes, others only every three months.

In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested.

Fees and Expenses

Administrative costs, typically less than 0.5% of the assets, are charged to the participants. There are a number of different plan expenses and fees, including:

• Investment fees
• Plan administration fees, including:
  • Management fees charged by the broker
  • Sales charges (loads or commissions)
  • Other fees, such as investment advice, furnishing statements, record keeping, and so on.
• 401(k) plan investment and services

Rollovers

If the employee leaves the company, they can choose to do a number of things.

1. Receive the total of the retirement account balance in cash.

This, however, will result in taxes and penalties; usually a 10% penalty in addition to the applicable local, state and federal taxes.

2. Keep the account with the employer

If the employer's plan offers good investment choices, then the participant may simply choose to leave the account with the current employer. The account must have at least $5,000 and no additional contributions can be made to that account.

3. Rollover the balance into another retirement plan.

The money may be moved into another tax-deferred account within 60 days; however, this must be done through a trustee or custodian to avoid paying penalty fees and taxes.

4. Rollover the balance into a new employer's 401(k) plan.

If the new company's plan has better options and/or lower fees, then the participant may choose to consolidate their retirement accounts into this new plan. This must be done within 60 days. The money can also be rolled over to an IRA while the new employer's 401(k) is ready.

Early Withdrawals

Early withdrawals are normally subject to a 10% penalty. However, a participant can take money out of a plan without a penalty in the following cases:

• after age 59 1/2
• financial hardship (such as buying a principal residence, paying college tuition, and paying for medical expenses that are not reimbursable)
• termination of employment
• disability
• death

In some cases, depending on the employer's rules, loans may be taken out of a 401(k). If allowed, a participant can borrow up to 50% of the vested account balance with a minimum of $1,000 and a maximum of $50,000. The loan is then paid back into the 401(k) account with interest through after-tax salary deductions. However, if the participant leaves the company, the loan must be paid back in full with interest immediately. Loans that are not paid in the designated period are considered withdrawals and therefore taxed as ordinary income in addition to the 10% penalty.

Retirement

The payment options after retirement will be specified by the individual 401(k) plan. These options include the following:

Annuities

Payments are transferred into an annuity and paid for life. They are taxed as ordinary income each time they are paid, and are therefore ineligible for transfer to an IRA.

Installment Payments

This option pays the market value of a fixed number of units held in the investment account each year. The tax paid on each installment will depend on the period of time over which the participant chooses to receive them. If the period is less than 10 years, the funds may be transferred to an IRA to continue the tax deferral. If the period is 10 years or more, then each one will be taxed at ordinary income rates in the corresponding year.

Lump Sum Payment

The participant can transfer the lump sum into an IRA to preserve the tax deferral of those funds until withdrawals begin. Alternatively, the participant may choose to take all the money in one payment and pay ordinary income taxes.

Beneficiaries

When opening a 401(k), the participant must designate a beneficiary, who will receive the plan's assets after the employee's death. If required, the participant may designate more than one beneficiary, specifying the percentage amounts for each.

If no beneficiary is stated and the participant dies before the age of 70 1/2, the IRS will distribute the account over a five-year period to the estate. If the participant dies after the age of 70 1/2, distributions of the account are based on the remaining life expectancy based on the Term Certain Method, and payments are made for a certain number of years until that original life expectancy figure is reached.