Writing for Investopedia, Mark P. Cussen consulted with several wealth management professionals including Elyse Foster, CFP® of Harbor Wealth Management and found many circumstances to ponder.
Since its inception in 1978, the 401(k) plan has grown to be the most popular type of employer-sponsored retirement plan in America. Millions of workers depend on the money that they have saved in this plan to provide for their retirement years, and many employers use their 401(k) plans as a means of distributing company stock to employees. Few other plans can match the relative flexibility that 401(k)s offer.
By definition, a 401(k) plan is an arrangement that allows an employee to choose between taking compensation in cash or deferring a percentage of it to a 401(k) account under the plan. The amount deferred is usually not taxable to the employee until it is withdrawn or distributed from the plan. However, if the plan permits, an employee can make 401(k) contributions on an after-tax basis (these accounts are known as Roth 401(k)s), and these amounts are generally tax-free when withdrawn. 401(k) plans are a type of retirement plan known as a qualified plan, which means that this plan is governed by the regulations stipulated in the Employee Retirement Income Security Act of 1974 (or ERISA) and the tax code.
For 2019, the maximum amount of compensation that an employee can defer to a 401(k) plan is $19,000 (up by $500 from 2018). Employees aged 50 by the end of the year and older can also make additional catch-up contributions of up to $6,000. The maximum allowable employer/employee joint contribution limit is $56,000 for 2019 (up by $1,000 from 2018) – $62,000 in 2019 for those aged 50 and older. The employer component includes matching contributions, non-elective contributions and/or profit-sharing contributions.
Typically, plan contributions are invested in a portfolio of mutual funds, but can include stocks, bonds and other investment vehicles as permitted under the provisions of the governing plan document.
The distribution rules for 401(k) plans differ from those that apply to IRAs. The money inside the plan grows tax-deferred, as with IRAs. However, whereas IRA distributions can be made at any time, a triggering event must be satisfied in order for distributions to occur from a 401(k) plan. As a result, 401(k) assets can usually be withdrawn only under the following conditions:
- Upon the employee’s retirement, death, disability or separation from service with the employer;
- Upon the employee’s attainment of age 59½;
- When the employee experiences a hardship as defined under the plan, if the plan permits hardship withdrawals;
- Upon the termination of the plan.
- The distribution occurs after the death or disability of the employee;
- The distribution occurs after the employee separates from service, providing the separation occurs during or after the calendar year that the employee attains age 55;
- The distribution is made to an alternate payee under a qualified domestic relations order (QDRO) as a part of a divorce or legal separation;
- The employee has deductible medical expenses exceeding 10% of adjusted gross income;
- The distribution is taken as a series of substantially equal periodic payments over the participant’s life or the joint lives of the participant and beneficiary;
- The distribution represents a timely correction of excess contributions or deferrals;
- The distribution is as a result of an IRS levy on the employee’s account;
- The distribution is not taxable.
Plan loans are another way that employees can access their plan balances, but several restrictions apply. First, the loan option is available at the employer’s discretion – if the employer chooses not to allow plan loans, no loans will be available. If this option is allowed, then up to 50% of the employee’s vested balance can be accessed, providing the amount does not exceed $50,000, and it must usually be repaid within five years. However, 401(k) loans used for primary home purchases can be repaid over longer periods.
The interest rate must be comparable to the rate charged by lending institutions for similar loans. Any unpaid balance left at the end of the term may be considered a distribution and will be taxed and penalized accordingly.
Limits for High-Income Earners
For most rank-and-file employees, the dollar contribution limits are high enough to allow for adequate levels of income deferral. However, the dollar contribution limits imposed on 401(k) plans can be a handicap for employees who earn several hundred thousand dollars a year. An employee who earns $750,000 in 2019 can only include the first $280,000 of income when computing the maximum possible contributions to a 401(k) plan. Employers have the option of providing non-qualified plans, such as deferred compensation or executive bonus plans, for these employees in order to allow them to save additional income for retirement. “Annuities would offer tax deferral of growth, but not a deduction,” says Allan Katz, president of Comprehensive Wealth Management Group, LLC in Staten Island, New York.
The Bottom Line
401(k) plans will continue to play a major role in the retirement planning industry for years to come. In this article, we have only touched on the major provisions of 401(k) plans. For more specific information on the options available to you, check with your employer and plan provider.
Original Source: Investopedia, Mark P. Cussen, The Basics of a 401(k) Retirement Plan