In addition to being asked the basic question “What is a 401(k) plan?”, we are often asked whether there are different types of 401(k) plans. Understanding how 401(k) plans function and the types available is an important first step in deciding what type of retirement savings plan may be most appropriate for your needs.
In simple terms, a 401(k) plan is one of several types of retirement saving plans an employer can establish for its employees. 401(k) plans are considered “qualified” plans because they meet certain procedural requirements established by the IRS which qualify them for favorable tax treatment. A 401(k) plan is a type of plan described under section 401(k) of the U.S. Tax Code.
A traditional 401(k) plan generally allows an employee to direct some of his or her compensation into a retirement account tax free. The portion contributed will not be taxed until it is withdrawn. A 401(k) plan can be set up as “profit sharing” in the sense that it can allow – but doesn’t have to require – an employer to make contributions on behalf of the employee. An employer’s contributions can either be a fixed percentage of an employee’s compensation, or the employer can make “matching contributions” by depositing the same amount the employee contributes up to a specified amount. Employer contributions can be in cash, or a 401(k) plan can be set up as a “stock bonus” or an “employee stock ownership” plan under which the employer contributes shares of stock or a combination of stock and cash. The amount an employer can contribute on behalf of all employees is subject to a maximum cap that the IRS adjusts annually, with additional contributions permitted on behalf of individuals over 50 years old.
Roth 401(k) plans are similar to traditional 401(k)s in that they allows employees to defer salary into a retirement savings plan and allows investments returns to accumulate tax free while in the plan; however, contributions made to a Roth 401(k) are taxable in the year they are made. The tax benefit of a Roth 401(k) is that the distributions are not taxed if they occur after retirement, so long as they otherwise comply with IRS guidelines.
If a plan meets these requirements, it will receive special tax treatment – the most important of which being that neither the contributions made to the plan, nor any of the investment returns, will be taxable to the employee until they are withdrawn. Of course, to get these tax benefits, 401(k) plans – like other tax deferred retirement plans – must comply with various IRS rules. Among other things, an employer with a 401(k) is not permitted to discriminate in favor of highly compensated employees – that is, if an employer has elected to contribute to the plan on behalf of employees, the employer must do so fairly among all participating employees and not favor highly compensated persons. Also, an employer may not arbitrarily prevent employees from participating in the plan. And an employee who stops working for an employer cannot be prevented from moving his or her funds elsewhere when the employee stops working for the employer. Most important, like other retirement plans, any funds deposited into a qualified plan must be invested, withdrawn, and distributed in strict compliance with rules laid out by the IRS.
401(k) plans can offer a tremendous amount of investment flexibility for both employers and employees. If you are an employer interested in establishing a 401(k) plan, we encourage you to contact us for more information.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with requirements by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.