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The 401(k) Investment Plan

A 401(k) plan is a retirement plan in the United States that is employer-sponsored and is named for a section of the United States Internal Revenue Code. 401(k) plans allow workers to defer income taxes on retirement savings until the invested funds are withdrawn.

Within the plan, an employee elects to have a portion of his/her wages paid directly into a 401(k) account. The most common option for a 401(k) account is called a participant-directed investment plan. This is where the employee can choose from many different investment options from mutual funds that focus on stocks, bonds, money market investments, or a combination of the above. Most public companies’ 401(k) plans allow for the purchase of the company’s own stock as well. At any time an employee can generally re-allocate invested funds among these investment choices. In less common trustee-directed 401(k) plans, the employer uses a trustee to decide how the plan’s funds are allocated.

Details of the 401(k) Plan

Since the 401(k) is an employee benefit, a 401(k) has to be sponsored by an employer, which is typically a private sector corporation. Any self-employed individual can set up their own 401(k) plan as well; however, government entities could only do so until 1986 when the code was changed. The employer acts as a plan fiduciary and is always responsible for designing the plan, as well as the selection and monitoring of plan investments. However, in practice, most employers outsource 401(k) plan monitoring to one or more financial services, such as a bank, mutual fund, administrative company, or insurance firm.

Under the IRS’s definition, a 401(k) is technically a kind of profit sharing plan that has a qualified Cash or Deferred Arrangement. It differs from a traditional pension plan or defined benefit plan because contributions are entirely voluntary and neither benefits nor contributions are defined within a 401(k) plan. However, profit sharing plans are not pension plans, they and defined contribution plans are both called individual account plans as each participant’s benefit is the value of an individual account. However, despite the classification, a 401(k) does not need to involve profit-sharing.

Covered by the Employee Retirement Income Security Act of 1974 (ERISA), 401(k) plans are tax-qualified plans, so assets that are held by the plans are entirely protected from creditors of the account holder, which in the past was not generally true for IRA plans. In cases of employer bankruptcy, 401(k) plans are also protected from the creditors of the company, whereas assets in a pension plan are not. Despite pension plans being backed by insurance through the Pension Benefit Guaranty Corporation, workers whose companies enter bankruptcy may never receive the full value of their pensions. The ERISA protection of 401(k) assets does not, however, extend to losses in the value of the underlying investments within the plan. Employees investing their 401(k) in their own employer stock face the possibility of losing the value of their retirement accounts that is invested in employer stock along with their jobs if their employer goes out of business.

Regardless of how the underlying plan assets perform, defined benefit plants have a definitely determinable benefit amount that is usually based on a fixed formula or return. According to Section 414(i) of the Internal Revenue Code (IRS), defined contribution plans have individual accounts. Since the plan sponsors want to take advantage of the exemption from the fiduciary duty to diversify plan assets to minimize the risk of large losses by using the ERISA Section 404(c). These plans usually provide each employee the ability to control the contents of their own accounts. The value of an account may also fluctuate in value based on the underlying investments. There is always a risk that the plan’s returns will even be negative.

Some companies even match employee contributions to some extent, paying extra money into the employee’s 401(k) account as an inventive for the employee to save even more money for retirement. The employer may alternatively make profit sharing contributions into the 401(k) plan or simply contribute a fixed percentage of the wages. These contributions may vest over several years as an inducement to the employee to stay with the employer.

When an employee leaves a job, the 401(k) account generally stays active for the rest of his or her life, though the accounts must begin to be drawn out beginning the April 1st of the calendar after the calendar year of attainment of age 70½ (except that under SBJPA 1996, those still employed can defer). In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, when the employee leaves the company, the account can be rolled over into an IRA at an independent financial institution, or if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can "roll over" the account into a new 401(k) account hosted by the new employer.

Comparable types of salary-deferral retirement plans include 403(b) plans covering workers in educational institutions, churches, public hospitals, and non-profit organizations and 457 plans which cover employees of state and local governments and certain tax-exempt entities.

New significant rules are allowing benefits companies (Plan Providers) and those involved in selling benefits to plans (Plan Advisors) to expand and extend their capabilities to sell services to Plan Sponsors who are responsible for managing employer sponsored retirement plans for companies.

 

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