WHAT IS A 401K PLAN
The 401(k) plan takes its name from the U.S. Internal Revenue Service Code, where section 401(k) allows businesses to establish tax-favored retirement savings accounts for their employees. 401(k) plans have grown to become a major source of retirement savings due to their unique benefits. About one-quarter of all retirement savings in the U.S. are held in 401(k) plans.
The 401 (k) plan is just one of many alternative ways the U.S. government provides for tax-favored savings for retirement. 401(k) plans differ from Individual Retirement Accounts (IRAs) in that IRAs are usually held by individuals-as the name suggests-rather than by companies. In 2011, 61% of Americans had a 401(k) or other employer-provided retirement account, 39% had an IRA account, 31% had both an IRA and a 401(k), and 31% had neither, according to the Investment Company Institute.
HOW DO 401K PLANS WORK
401(k) plans can only be set up by employers, and usually involve employers making tax-deferred, direct contributions to employee retirement accounts. With IRAs, most if not all of the contributions come from the employee, who usually has control over how the funds are invested. With 401 k plans, both employers and employees usually contribute, and a custodian provides limited options that employees can choose between when investing their savings.
The paperwork requirements are also different for IRAs and 401(k)s. Employers do not have to file any paperwork with an IRA, other than showing the amount of compensation directed to the IRA account on an employee's W-2 annual summary wages and deductions. Companies with a 401k plan must file Form 5500 with the IRS each year, and must satisfy annual anti-discrimination testing to ensure that highly compensated employees are not benefiting in an unbalanced way from the company's 401(k) contributions.
TYPES OF 401K PLANS
The IRS allows for some variety of structures for 401(k) plans. These include a Roth 401(k), a Safe Harbor 401(k), and a SIMPLE 401(k). Let's quickly take a look at these options.
- Traditional 401(k): Employers may contribute, but are not required to. Contributions are not taxed, nor are earnings, until funds are distributed-usually after retirement. Early distributions for other than approved reasons incur both income taxes and penalties. Major advantages of a traditional 401(k) are that employer contributions may be vested over time, and employees can borrow against the funds. One disadvantage is the increased reporting requirements, and thus administrative costs, compared with SIMPLE or Safe Harbor plans.
- Roth 401(k): Employers may contribute, but are not required to. Unlike a traditional 401(k), contributions to a Roth account are made after taxes are taken out. Earnings on a Roth account are usually tax-free if distributed after the age of 59.5, whereas earnings on a traditional 401(k) are taxed when distributed. Roth accounts are usually offered in addition to a pre-tax savings plan. These accounts work well for very young savers and people who believe they will be in a higher tax bracket when funds are distributed than when funds are contributed.
- Safe Harbor 401(k): This is similar to a traditional 401(k) plan, except that the employer contribution of funds must be vested immediately. The paperwork for these IRAs is simplified, and no anti-discrimination tests are required each year. Employees may not borrow against these funds. Safe Harbor plans are usually used by companies with highly compensated employees who want to contribute large amounts without anti-discrimination limits.
- SIMPLE 401(k): This 401(k) is designed to provide a cost-efficient way for small employers to offer an affordable retirement savings plan to their owners and employees. Like a Safe Harbor plan, employers must vest contributions immediately, and are not required to perform anti-discrimination tests and other paperwork. Employers must contribute to SIMPLE plans, matching employee contributions up to 3% of wages, or contributing a minimum of 2% of wages. You can't borrow against these plans, and contributions must be made through payroll deductions. SIMPLE plans are limited to employers with fewer than 100 employees who earn more than $5,000 per year, and can't be used if the employer offers another type of retirement plan. The benefits of using a SIMPLE plan? Easy to set up and lower administrative costs.
Related: See Our Full Guide to 401K plans
WHY GET A 401K
The main benefit of 401(k) plans is their tax-favored status. Employee contributions are deducted before taxes are calculated, and earnings on the investment are also not subject to taxes when earned. The contributions and the gains are only taxed when distributed, typically after retirement, and usually at a lower tax rate. Employer contributions to 401(k) plans are tax-deductible to the employer.
Many 401(k) plans include some employer matching of employee contributions to their retirement funds. 401(k) programs are extremely popular with employees, so much so that employers offering these plans find it easier to attract qualified employees. In a recent study by the U.S. Office of Personnel Management, 91% of employees rated retirement benefits as a major reason for accepting or continuing employment-more than any other benefit-even including health-care coverage (89%)!
CALCULATING COSTS OF A 401K
Most plans will provide you with a stated cost of administering the plan, a projected annual rate of return, and a history of the performance of the funds they manage. It's fairly easy to compare providers on these criteria. Where it gets tricky is all the hidden fees, costs to the employer, and the value of customer-service capabilities. Providers can be very clever about slipping in unexpected fees. The checklist below will help prevent any surprises when deciding between plans.
Here are some typical costs for 401(k) plans:
Set-up charge $500 - $5,000 (typical is $1,000)
Annual base fee $250 - $3,000
Monthly base fee $100 - $500
Annual charge per employee $0 - $50
Investment fee - annual $40 - $100
Investment fee - percentage .15% - 1.0% of asset value
12b-1 fee (.15% - 1.0% of assets)
401K PURCHASING TIPS
- Don't go outside the box. Investment funds have been around long enough so that most provide very similar packages, rates of return, and fees. Unless you really know what you're doing, stay away from funds where the investment vehicles are unusual or the rates of return seem inflated. When it comes to investing your employees' retirement funds, extra caution is warranted.
- Avoid investment seminars. The North American Securities Administrator Association (NASAA) released a report showing a high level of investment fraud resulting from in-person seminars. Avoid situations where sales reps have you trapped. Do your homework online so that you have access to a wide variety of resources.
- It's the service, not the fee. While your employees may be focused only on a rate of return, as an employer you should make an effort to compare customer-service features and reputations. If the fund is generating great success in returns after expenses, is it because it has shifted the costs of service onto you, the employer? With most major investment funds thoroughly regulated, rated, and reviewed, the major differences between providers may come down to customer-service amenities. Ask about customer service, and check reputations online. You could be paying a lot more for the "least expensive" fund than for one with full-featured customer support.
401K GLOSSARY OF TERMS
Anti-Discrimination Testing: Tests performed to ensure that highly compensated employees are not benefiting disproportionately from a company's contributions to employee retirement accounts.
Asset Allocation: The distribution of an employee's retirement account between different assets, such as equity funds, bond funds, real estate funds, growth funds, income funds, etc.
Balancing: Portfolio balancing is the art of distributing funds between assets with risk/reward profiles that blend to achieve one's financial goals.
401(k): A form of employer-sponsored retirement savings account setup under Internal Revenue Service Code section 401(k), which lays out the rules and rights for such funds.
Form 5500: Annual federal tax return employers are required to file documenting activities in a company's 401(k) plan.
403(b): Similar to a 401(k) plan, a 403(b) plan can only be used by nonprofit organizations, including certain schools, hospitals, and ministries.
Individual Retirement Accounts (IRAs): The U.S. Congress enabled these accounts to allow people to save for retirement on a pre-tax basis, thus encouraging saving.
Roth IRA: An individual retirement account where contributions are made after-tax, earnings grow tax-free, and distributions are not subject to income tax. Usually offered in addition to a pre-tax retirement account.
Safe Harbor 401(k): A retirement savings account specifically designed for highly compensated employees. It does not have to meet anti-discrimination tests.
SIMPLE 401(k): A retirement savings account designed for small businesses, with more rigid rules and lower reporting requirements and administrative costs.
12b-1 Fee: A fee charged by some supposedly "no-load" mutual funds for fund operation expenses. Can run anywhere from .15% to 1.0% of assets.
Vesting: Vesting is when an employer funds a contribution to employee retirement savings accounts. Many employers vest their contributions at the end of the year. Some plans require immediate vesting, while others allow employers to vest their contributions over a lengthy period of time.