401(k)

A 401(k) plan is a retirement savings plan that is funded by employee contributions. Often it is additionally funded by matching contributions from the employer. One of the key points of these plans is that the contributions are taken out of your salary before taxes. Also the funds grow tax-free until withdrawn. But you do get taxed when you withdrawl it from the plan. Also there are penelties if you don't meet the withdrawl requirements (you are 59 1/2, or using the money to buy a home, or some other things).

These plans can be setup by for-profit and many tax-exempt organizations for use by their employees. The 401(k) plan gets its name from the section of the Internal Revenue Code of 1978.

It is a VERY good idea to get take advantage of this if your employer offers one. The sooner the better. But like all investment desicions you should do some research on it to find out how you can best take advantage of it, what some of the down-sides are, and how not to make mistakes with it to maximize your returns.

OK, here's a piece of advice for you folks just entering the job market:

As soon as you can, invest in a 401(K) plan. Invest as much as your employer and the government allows. Hopefully, he will match some or all of your investment. If he does not, don't get all huffy. Just go ahead and do this for yourself.

This may all seem stupid to you now, but you will wake up one day and be, say, 40-something years old, and you'll have several thousands of dollars that you didn't even miss. And, if you're really, really smart, you'll start to figure the amount you saved in taxes. Unless you're a liberal Democrat who thinks we all need to pay more taxes. See stupid idea.

Section 401(k) of Title 26 - Internal Revenue Code

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(k) Cash or deferred arrangements

(k)(1) General rule

A profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan shall not be considered as not satisfying the requirements of subsection (a) merely because the plan includes a qualified cash or deferred arrangement.

(k)(2) Qualified cash or deferred arrangement

A qualified cash or deferred arrangement is any arrangement which is part of a profit-sharing or stock bonus plan, a pre-ERISA money purchase plan, or a rural cooperative plan which meets the requirements of subsection (a) -

• (A) under which a covered employee may elect to have the employer make payments as contributions to a trust under the plan on behalf of the employee, or to the employee directly in cash;
• (B) under which amounts held by the trust which are attributable to employer contributions made pursuant to the employee's election -
  • (i) may not be distributable to participants or other beneficiaries earlier than -
    • (I) separation from service, death, or disability,
    • (II) an event described in paragraph (10),
    • (III) in the case of a profit-sharing or stock bonus plan, the attainment of age 59 1/2, or
    • (IV) in the case of contributions to a profit-sharing or stock bonus plan to which section 402(a)(8) applies, upon hardship of the employee, and
  • (ii) will not be distributable merely by reason of the completion of a stated period of participation or the lapse of a fixed number of years;
• (C) which provides that an employee's right to his accrued benefit derived from employer contributions made to the trust pursuant to his election is nonforfeitable, and
• (D) which does not require, as a condition of participation in the arrangement, that an employee complete a period of service with the employer (or employers) maintaining the plan extending beyond the period permitted under section 410(a)(1) (determined without regard to subparagraph (B)(i) thereof).

(k)(3) Application of participation and discrimination standards

• (A) A cash or deferred arrangement shall not be treated as a qualified cash or deferred arrangement unless -
  • (i) those employees eligible to benefit under the arrangement satisfy the provisions of section 410(b)(1), and
  • (ii) the actual deferral percentage for eligible highly compensated employees (as defined in paragraph (5)) for such year bears a relationship to the actual deferral percentage for all other eligible employees for such plan year which meets either of the following tests:
    • (I) The actual deferral percentage for the group of eligible highly compensated employees is not more than the actual deferral percentage of all other eligible employees multiplied by 1.25.
    • (II) The excess of the actual deferral percentage for the group of eligible highly compensated employees over that of all other eligible employees is not more than 2 percentage points, and the actual deferral percentage for the group of eligible highly compensated employees is not more than the actual deferral percentage of all other eligible employees multiplied by 2.

      If 2 or more plans which include cash or deferred arrangements are considered as 1 plan for purposes of section 401(a)(4) or 410(b), the cash or deferred arrangements included in such plans shall be treated as 1 arrangement for purposes of this subparagraph.

      If any highly compensated employee is a participant under 2 or more cash or deferred arrangements of the employer, for purposes of determining the deferral percentage with respect to such employee, all such cash or deferred arrangements shall be treated as 1 cash or deferred arrangement.

• (B) For purposes of subparagraph (A), the actual deferral percentage for a specified group of employees for a plan year shall be the average of the ratios (calculated separately for each employee in such group) of -
  • (i) the amount of employer contributions actually paid over to the trust on behalf of each such employee for such plan year, to
  • (ii) the employee's compensation for such plan year.
• (C) A cash or deferred arrangement shall be treated as meeting the requirements of subsection (a)(4) with respect to contributions if the requirements of subparagraph (A)(ii) are met.
• (D) For purposes of subparagraph (B), the employer contributions on behalf of any employee -
  • (i) shall include any employer contributions made pursuant to the employee's election under paragraph (2), and
  • (ii) under such rules as the Secretary may prescribe, may, at the election of the employer, include -
    • (I) matching contributions (as defined in 401(m)(4)(A)) which meet the requirements of paragraph (2)(B) and (C), and
    • (II) qualified nonelective contributions (within the meaning of section 401(m)(4)(C)).

(k)(4) Other requirements

(k)(4)(A) Benefits (other than matching contributions) must not be contingent on election to defer

A cash or deferred arrangement of any employer shall not be treated as a qualified cash or deferred arrangement if any other benefit is conditioned (directly or indirectly) on the employee electing to have the employer make or not make contributions under the arrangement in lieu of receiving cash. The preceding sentence shall not apply to any matching contribution (as defined in section 401(m)) made by reason of such an election.

(k)(4)(B) State and local governments and tax-exempt organizations not eligible

A cash or deferred arrangement shall not be treated as a qualified cash or deferred arrangement if it is part of a plan maintained by -

• (i) a State or local government or political subdivision thereof, or any agency or instrumentality thereof, or
• (ii) any organization exempt from tax under this subtitle.

This subparagraph shall not apply to a rural cooperative plan.

(k)(4)(C) Coordination with other plans

Except as provided in section 401(m), any employer contribution made pursuant to an employee's election under a qualified cash or deferred arrangement shall not be taken into account for purposes of determining whether any other plan meets the requirements of section 401(a) or 410(b). This subparagraph shall not apply for purposes of determining whether a plan meets the average benefit requirement of section 410(b)(2)(A)(ii).

(k)(5) Highly compensated employee

For purposes of this subsection, the term 'highly compensated employee' has the meaning given such term by section 414(q).

(k)(6) Pre-ERISA money purchase plan

For purposes of this subsection, the term 'pre-ERISA money purchase plan' means a pension plan -

• (A) which is a defined contribution plan (as defined in section 414(i)),
• (B) which was in existence on June 27, 1974, and which, on such date, included a salary reduction arrangement, and
• (C) under which neither the employee contributions nor the employer contributions may exceed the levels provided for by the contribution formula in effect under the plan on such date.

(k)(7) Rural cooperative plan

For purposes of this subsection -

(k)(7)(A) In general

The term 'rural cooperative plan' means any pension plan -

• (i) which is a defined contribution plan (as defined in section 414(i)), and
• (ii) which is established and maintained by a rural cooperative.

(k)(7)(B) Rural cooperative defined

For purposes of subparagraph (A), the term 'rural cooperative' means -

• (i) any organization which -
  • (I) is exempt from tax under this subtitle or which is a State or local government or political subdivision thereof (or agency or instrumentality thereof), and
  • (II) is engaged primarily in providing electric service on a mutual or cooperative basis,
• (ii) any organization described in paragraph (4) or (6) of section 501(c) and at least 80 percent of the members of which are organizations described in clause (i),
• (iii) a cooperative telephone company described in section 501(c)(12), and
• (iv) an organization which is a national association of organizations described in clause (i), (ii), or (iii).

(k)(8) Arrangement not disqualified if excess contributions distributed

(k)(8)(A) In general

A cash or deferred arrangement shall not be treated as failing to meet the requirements of clause (ii) of paragraph (3)(A) for any plan year if, before the close of the following plan year -

• (i) the amount of the excess contributions for such plan year (and any income allocable to such contributions) is distributed, or
• (ii) to the extent provided in regulations, the employee elects to treat the amount of the excess contributions as an amount distributed to the employee and then contributed by the employee to the plan.

Any distribution of excess contributions (and income) may be made without regard to any other provision of law.

(k)(8)(B) Excess contributions

For purposes of subparagraph (A), the term 'excess contributions' means, with respect to any plan year, the excess of -

• (i) the aggregate amount of employer contributions actually paid over to the trust on behalf of highly compensated employees for such plan year, over
• (ii) the maximum amount of such contributions permitted under the limitations of clause (ii) of paragraph (3)(A) (determined by reducing contributions made on behalf of highly compensated employees in order of the actual deferral percentages beginning with the highest of such percentages).

(k)(8)(C) Method of distributing excess contributions

Any distribution of the excess contributions for any plan year shall be made to highly compensated employees on the basis of the respective portions of the excess contributions attributable to each of such employees.

(k)(8)(D) Additional tax under section 72(t) not to apply

No tax shall be imposed under section 72(t) on any amount required to be distributed under this paragraph.

(k)(8)(E) Treatment of matching contributions forfeited by reason of excess deferral or contribution

For purposes of paragraph (2)(C), a matching contribution (within the meaning of subsection (m)) shall not be treated as forfeitable merely because such contribution is forfeitable if the contribution to which the matching contribution relates is treated as an excess contribution under subparagraph (B), an excess deferral under section 402(g)(2)(A), or an excess aggregate contribution under section 401(m)(6)(B).

(k)(8)(F) Cross reference

For excise tax on certain excess contributions, see section 4979.

(k)(9) Compensation

For purposes of this subsection, the term 'compensation' has the meaning given such term by section 414(s).

(k)(10) Distributions upon termination of plan or disposition of assets or subsidiary

(k)(10)(A) In general

The following events are described in this paragraph:

(k)(10)(A)(i) Termination

The termination of the plan without establishment or maintenance of another defined contribution plan (other than an employee stock ownership plan as defined in section 4975(e)(7)).

(k)(10)(A)(ii) Disposition of assets

The disposition by a corporation of substantially all of the assets (within the meaning of section 409(d)(2)) used by such corporation in a trade or business of such corporation, but only with respect to an employee who continues employment with the corporation acquiring such assets.

(k)(10)(A)(iii) Disposition of subsidiary

The disposition by a corporation of such corporation's interest in a subsidiary (within the meaning of section 409(d)(3)), but only with respect to an employee who continues employment with such subsidiary.

(k)(10)(B) Distributions must be lump sum distributions

(k)(10)(B)(i) In general

An event shall not be treated as described in subparagraph (A) with respect to any employee unless the employee receives a lump sum distribution by reason of the event.

(k)(10)(B)(ii) Lump sum distribution

For purposes of this subparagraph, the term 'lump sum distribution' has the meaning given such term by section 402(e)(4), without regard to clauses (i), (ii), (iii), and (iv) of subparagraph (A), subparagraph (B), or subparagraph (H) thereof.

(k)(10)(C) Transferor corporation must maintain plan

An event shall not be treated as described in clause (ii) or (iii) of subparagraph (A) unless the transferor corporation continues to maintain the plan after the disposition.

As strange as it may seem, 401(k) plans were created by mistake, and even came under threat of elimination in the early 1980s (under conservative champion Ronald Reagan, no less!).

In 1978, the US Congress passed the Revenue Act of 1978, which was intended to clear up a bureaucratic dispute between the Treasury Department and Congress over the taxation of certain tax deferred retirement plans. This it did, but the new section also seemed to open a door to a new type of plan, referred to technically as a cash or deferred arrangement or CODA.

But few people saw the potential of this new opportunity. The first company to establish a 401(k) plan was the Johnson Companies, an employee benefits consulting firm part owned by R. Theodore Benna--now referred to as "The father of the 401(k)." It was innovative, it allowed employees a more active hand in planning for their own retirements, and (despite some early challenges) it was shown to be legal. The year was 1981.

A few people in the Reagan administration began to sit up and take notice. While they had made a campaign pledge to expand IRAs, this new development--and its potential to decrease tax revenue--took them by surprise. A worried Jack Kemp estimated that the new plans would decrease tax receipts by $4-5 billion per year. These estimates were wrong--the annual shortfall was more than double the expectation.

The next few years saw a 401(k) explosion throughout the country, as companies converted existing plans to this new format. The benefit to business was clear: while they may still have offered matching contributions, the ability to let employees save through elective salary deferrals meant a lower up front cost. Nevertheless, the 401(k) had to weather several legislative challenges. For example, the Tax Reform Act of 1986 severely limited the maximum amount workers could contribute; and the Unemployment Compensation Act of 1992] imposed a kind of "stealth tax" when employess sought to "roll" their assets out of the plans.

But as the years have passed, the old model defined benefit plans have given way to the defined contribution system (primarily represented by the 401(k)), to such a degree that repeal now seems out of the question. And a damn good thing, too.