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A 401(k) plan is a retirement savings plan that is funded by employee contributions and often matching contributions from the employer. The major attraction of these plans is that contributions are taken from pre-tax salary, and the funds grow tax-free until withdrawn. Also, the plans are (to some extent) self-directed, and they are portable. Both for-profit and many types of tax-exempt organizations can establish these plans for their employees.


Participants in a 401(k) plan generally have a number of different investment options, nearly all cases a menu of mutual funds. These funds usually include a money market fund, bund funds of varying maturities and various stock funds. The employee chooses how to invest the savings and is typically allowed to change where current savings are invested and/or where future contributions will go a specific number of times a year. The employee is also typically allowed to stop contributions at any time.

Employees have the option of making all or part of their contributions from pre-tax (gross) income. This has the added benefit of reducing the amount of tax paid by the employee from each check now and deferring it until the person takes the pre-tax money out of the plan. Both the employer contribution (if any) and any growth of the fund compound tax-free.
A participant’s maximum before-tax contribution (i.e. 401(k) limit) for 2005 is $14,000. It is important to understand this limit. This figure indicates only the maximum amount that the employee can contribute from his/her pre-tax earnings to all of his/her 401(k) accounts. It does not include any matching funds that the employer might graciously throw in. Further, this figure is not reduced by monies contributed towards many other plans (like an IRA). If a participant works for two or more employers during the year, then he/she has the responsibility to make sure they contribute no more than that year’s limit between the two or more employers’ 401k plans. If the employee accidentally contributes more than the pre-tax limit towards his/her 401k account, the employee must contact the employer. The excess might be refunded or re-classified as an after tax contribution.

The maximum before-tax contribution limit is subject to the catch-up provision, which is available to employees who are over 50 years old. This provision allows these employees to contribute extra amounts over and above the limit in effect for that year. The additional contribution amount is $4,000 in 2005 and $5,000 in 2006. Thereafter, it increases by $500 annually.

There are regulations for highly compensated employees. As of 2005, the IRC defines “highly compensated” as income in excess of $95,000; alternately, the company can make a determination that only the top 20% of employees are considered highly compensated. Therefore, the implementation of the highly compensated employee regulations varies with the company.

IRS rules won’t allow contributions on pay over a certain amount. The 2005 limit is $210,000 and it changes annually. Also, the IRS limits the total amount of deferred income (i.e. money in IRAs, 401k plans, 401a plans, or pension plans) each year to the lesser of some amount ($42,000 in 2005, and subject to change) or 25% of your annual compensation. Annual compensation is defined as gross compensation for the purpose of computing the limitation. This changes an earlier law; a person’s annual compensation for the purpose of this computation is no longer reduced by 401k contributions and salary redirected to cafeteria benefit plans.

Unlike IRA or other retirement savings accounts, 401k plans allow limited, penalty-free access to savings before age 59.5. It is legal to take a loan from your 401k before age 59.5. The tax code does not specify exactly what loans are permitted, jus that loans must be made reasonably available to all participants. The employer can restrict loans for purposes such as covering unreimbursed medical expenses, buying a house, or paying for education. When a loan is obtained, you must pay the loan back with regular payments (these can be set up as payroll deductions), but you are, in effect, paying yourself back both the principal and the interest, not a bank. If you take a withdrawal from your 401k as money other than a loan, you must pay tax on any pre-tax contributions and on the growth, as well as a 10% pre-distribution penalty.

Since a 401k is a company-administered plan, and every plan is different, changing jobs will affect your 401k plan significantly. Be extremely careful regarding rollovers. Employees taking a withdrawal have the opportunity to make a “direct rollover” of the taxable amount of a 401k to a new plan. This means the check goes directly from one company to another (or new plan). If this is done (i.e. the employee never touches the money), no tax is withheld or owed on the direct rollover amount. If the direct rollover is not chosen (employee receives check), the withdrawal is immediately subject to a mandatory tax withholding of 20% of the taxable portion, which the old company is required to send to the IRS. The remaining 80% must be rolled into a new retirement account within 60 days or it is subject to the 10% tax mentioned above.

Always consult a tax professional with any questions regarding the management of a 401k.

Last Updated: 9/23/2012 10:05:00 PM