401k
The 401(k) plan is a type of defined contribution pension plan available in the United States. Named after a section of the 1978 Internal Revenue Code, it is a device to provide tax advantages on money set aside for retirement. Comparable types of retirement plans include 403(b) plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and the 401(a) and 457 plans which cover employees of state and local governments and certain tax-exempt entities.
401(k) plans must be sponsored by an employer, typically a private sector corporation; changes in the tax code bar governmental employers from offering 401(k) plans unless they were established before May 1986. The employer acts as a plan fiduciary and is responsible for creating and designing the plan as well as selecting and monitoring plan investments.
The employee asks to have part of his salary paid directly, or deferred, into the 401(k) fund. In participant-directed plans the employee can then select from a number of investment options. In trustee-directed 401(k) plans the employer appoints trustees who decide how the plan's assets will be invested.
Taxes on contributions to 401(k) plans and the earnings on those contributions are deferred until the money is withdrawn from the plan. At the time money is withdrawn from the plan it is taxed as regular income. Withdrawals are typically made at or after retirement. In most cases in which employees take money from accounts prior to retirement, they must pay a 10 percent penalty to the IRS.
The first 401(k) was created in 1980 by Theodore Benna, a consultant working for The Johnson Companies. Originally intended for executives, during the decade of the 1990s the plan proved popular with workers at all levels because it offers greater flexibility than Individual Retirement Accounts (IRAs). 401(k) plans have higher yearly contribution limits than IRAs. Also, 401(k) plans are tax-qualified plans covered by the Employee Retirement Income Security Act of 1974 (ERISA) which means that assets held by the plans are protected from creditors. That protection does not apply to IRA accounts in some states.
Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at low, pre-defined interest rates. The interest proceeds then become part of the 401(k) balance.
401(k) plans also proved popular with employers looking for ways to reduce their pension costs. In most cases, defined contribution plans are less expensive than defined benefit plans for employers. 401(k) plans also create a predictable cost for employers while the cost of defined benefit plans can vary unpredictably from year-to-year.
401(k) plans for certain small businesses or sole proprietorships
Many self-employed persons felt (and financial advisors agreed) that 401(k) plans weren't in tune with their needs due to the high costs and difficult administration. But the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made 401(k) plans simpler to set up for self employed persons. While EGTRRA did not explicitly create a new type of retirement plan, it made a number of constructive changes to existing laws governing 401(k) plans.
Specifically, an employer with only employees meeting the definition of 'highly compensated' can now set up a 401(k) plan without having to carry out the expensive discrimination testing most large plans must do. The definition of highly compensated is unusual in that it takes into account not only the expected income requirement, but also includes direct family members such as the owner's spouse, children, and parents. In addition, if the plan has less than $100,000 in assets, it is exempt from filing the complicated annual 5500 tax form. The legislation thus had an unintended benefit of more easily allowing higher contribution limits for qualifying small employers. Many vendors now offer these type of plans which are often called Solo 401(k) or Individual(k) plans.
