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 Personally, we think that 401k plans are one of the premier benefits an employer can offer their workers. They provide employees a perfect tax shelter, and most plans even include an instant return on the employee's investment. In fact, for many investors 401k plans should be their first stop for any money earmarked for retirement.
401k Plans versus IRAs
One of the nice features of 401k plans is that they allow all participants to set retirement money aside on a pre-tax basis. That's an important point because many employees that are already covered by retirement plans are not eligible to contribute to traditional IRAs on a tax-deferred basis. But these same employees can contribute $15,500 or more to a 401k in 2007 and 2008.
Employer Matching
Another nice feature of 401k plans is the employer match. Many employers will match their employee contributions either on a dollar-for-dollar basis or on a percentage basis. For example, an employer might contribute $0.50 for every dollar the employee contributes to their 401k account. This amounts to an instant 50% return on the employee's investment. You'd be hard pressed to find any other legal way to get a return like that - talk about free money!
401k Participation Rules
In order for your employer to set up a 401k plan, they really only have to comply with about four rules. The first rule is that the plan must be written down. That means all of the participation rules and matching contributions limits must be spelled out.
The second rule has to do with safekeeping the fund. The company must provide for a trust fund for the plan's assets. In practice, this trust can be provided by the company itself or by other entities such as a brokerage house. The intention here is that the money needs to be managed in a professional and secure manner. This rule dovetails nicely with the third employer requirement - there needs to be a recordkeeping database.
The final employer rule is a pretty simple one to follow. All of the information on how the plan works needs to be shared with the potential participants or employees.
Federal Rules that Apply to 401k Plans
The IRS has established several strict ground rules in the way 401k plans are run, but they've also left some flexibility for employers in terms of participation rules. So while the exact 401k rules of participation are a little loose, there are generally three rules all employers must follow:
- In order to participate in a 401k plan, the employee must be age 21 or older.
- Employees may be required to work for the company for at least one year before participating.
- If the employee is also covered by a collective bargaining agreement, and they've negotiated on this benefit in good faith, then as part of that negotiation process, the union employees may not be eligible for participation.
401k Contribution Limits in 2007 and 2008
There are three 401k contribution limits that apply in the years 2007 and 2008. These limits cover the contributions of the employees themselves, the employer, and whether or not the contribution is made on a pre-tax or an after-tax basis.
Employee Contributions
For the calendar years 2007 and 2008, the employee can contribute up to $15,500 on a pre-tax basis. In 2009, employees' contributions will be determined via an index of inflation and move up in $500 increments. If you're 50 or older by year's end, then you are also eligible for the catch-up contribution discussed later in this article.
Employer Contributions
When figuring out contribution limits, employer contributions are counted separately from the employee contributions mentioned above. Employer's contributions are limited to 6% of the employee's pre-tax income. That includes any direct contribution an employer may make into an account or any of the matching contributions discussed later.
Finally, the total of all contributions to an employee's 401k plan, including matching contributions, catch-up provisions, and the employee's pre-tax and after-tax contributions cannot exceed 100% of the employee's compensation.
Catch-up Contributions
If you reach the age of 50 or more by December 31st, then you are eligible for an additional catch-up contribution. For the calendar years 2007 and 2008, employees can make an additional $5,000 contribution to their 401k plan on a pre-tax basis. In 2009, the catch-up contribution will be indexed to inflation and can rise in $500 increments.
Matching Contributions
We mentioned earlier that employers had some flexibility around the participation rules they establish. That's because each year the employer's 401k plan must pass a test that the IRS conducts to ensure robust participation in the plan. Essentially, the IRS wants to ensure that the benefits of the plan are flowing to both highly-compensated employees and rank-and-file employees.
This annual audit is one of the reasons employers make matching contributions. Whereas many of the highly compensated employees may have discretionary income that allows them to set money aside for retirement, the same cannot be said for some of the rank-and-file employees. In order to improve participation among the sector of employees that are unsure if they can afford to invest in the plan, the matching contribution is often the deciding factor.
401k Plan Vesting
All of the money an employee contributes to a 401k plan is immediately vested in the plan. That means regardless of the employee's tenure, or time spent, with the company this money cannot be forfeited and must remain in their 401k account or moved via a 401k rollover. Of course the employee's contribution can also increase or decline in value, depending on how the money was ultimately invested. But the bottom line is that the employee's contribution is always theirs to keep along with any growth or decline in its value.
In most 401k plans, it is up to the employer to decide when the employer match, if offered under the plan, is vested. Generally, this vesting would take place after five years or less of service, but only your program administrator can provide the exact rule. Since this is a very important rule for any 401k plan, the vesting rules should be spelled out in the plan's information materials and distributed to all participants.
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