It's well known in the financial community that 401(k) 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 contributions. In fact, for many investors 401(k) plans should be their first stop for any money earmarked for retirement.
One of the nice features of 401(k) plans is they allow all participants to set retirement money aside on a pre-tax basis. That's an important point, because employees that are already covered by retirement plans are often not eligible to contribute to Traditional IRAs on a tax-deferred basis. But these same employees can contribute $19,500 or more to a 401(k) in 2020 and 2021.
Another nice feature of 401(k) 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 401(k) account. This amounts to an instant 50% return on the employee's investment.
In order for an employer to set up a 401(k) plan, they 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 contribution 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 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 simple one to follow. All of the information explaining how the plan works needs to be shared with the potential participants or employees.
The IRS has established several strict ground rules for the way 401(k) plans are run, but they've also left some leeway for employers in terms of participation rules. So while the exact 401(k) rules of participation are somewhat flexible, there are generally three rules all employers must follow:
There are three 401(k) contribution limits that apply in the years 2020 and 2021. 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.
For the calendar years 2020 and 2021, the employee can contribute up to $19,500 on a pre-tax basis. In 2022, employees' contributions will be determined via an index of inflation, and can move up in $500 increments. Individuals 50 or older by year end are also eligible for the catch-up contribution discussed later in this article.
Note: Updated contribution limits are generally available in mid to late October.
Anyone reaching the age of 50 or more by December 31st is eligible for an additional catch-up contribution. Employees can make an additional - $6,500 in 2020 and 2021 - contribution to their 401(k) plan on a pre-tax basis. In 2022, the catch-up contribution will be indexed to inflation and can rise in $500 increments.
We mentioned earlier that employers had some flexibility around the participation rules they establish. Each year, the employer's 401(k) plan must pass a test the IRS conducts to ensure robust participation in the plan. Essentially, the IRS wants to ensure the benefits of the plan are flowing to both highly-compensated employees as well as rank-and-file members of the company.
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.
Finally, the total of all contributions to an employee's 401(k) plan, including matching funds, catch-up provisions, and the employee's pre-tax and after-tax contributions, cannot exceed 100% of the employee's compensation or $57,000 in 2020 and $58,000 in 2021.
Any money an employee contributes to a 401(k) plan is immediately vested in the plan. Regardless of the employee's tenure, or time spent with the company, this money cannot be forfeited and must remain in their 401(k) account or moved through a 401(k) rollover. Of course the employee's contribution can also increase or decline in value, depending on how the money was ultimately invested. The employee's contribution is always theirs to keep, along with any growth or decline in its value.
In most 401(k) plans, it is up to the employer to decide when the company's match, if offered under the plan, is vested. Generally, this vesting would take place after five years or less of service, but only the program administrator can provide the exact rule. Since this is a very important rule for any 401(k) plan, the vesting process should be spelled out in the plan's information materials and distributed to all participants.
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