In today’s highly regulated, financially sophisticated world, it can be hard to stay on top of all of the investment vehicles available to you. Even more frustrating can be learning how these financial products might fit into your overall plan for wealth accumulation and retirement savings. Educating yourself is your best defense, so we’ve created a three-part series on 401(k) plans. In this article, we’ll address 401(k) plan basics.
What is a 401(k) plan?
In basic terms, 401(k) plans are qualified retirement plans that allow employers to provide retirement income for employees. It is tax exempt, provided certain requirements are met.
401(k) plans allow employees to elect to have their employers make pre-tax contributions, referred to as salary deferrals, on the employees’ behalf in lieu of paying an equivalent amount in currently taxable cash wages. These plans are sometimes called “cash or deferred arrangements,” or CODAs.
In addition to salary deferrals made by plan participants, employers can make matching contributions, as well as discretionary profit sharing contributions. All of these contributions and the related investment earnings, or losses, on those contributions accumulate on a tax-deferred basis. Taxes are paid on the contributions when the money is withdrawn.
Self-employed individuals and working owners of closely-held corporations may find 401(k) plans especially attractive. Such individuals may benefit the most from the plan since they probably have the longest service in which to accumulate a benefit. They may also be allowed a greater contribution since their compensation is likely higher than that of other employees. This is especially true if the owner is the only participant, or when contributions to other participants are minimal in comparison to the owner’s.
401(k) Funding Sources
A 401(k) plan is funded from some or all of these sources:
- Employer Discretionary Contributions
- Employee Salary Deferrals
- Employer Matching Contributions
- Investment Earnings, or Losses
401(k) Contribution Limits for 2012
The amount an individual can contribute to an employer-sponsored retirement plan is the lesser of 100% of a participant’s salary or $17,000. For participates who are age 50 and older, an additional $5,500 can be saved as a “catch-up” contribution.
In future articles, we’ll explain the different types of contributions, how vesting works and how withdrawals and loans can be made from the account. By learning more about 401(k) plans work, you can decide if they are a good retirement savings vehicle. We also recommend that you work with your financial and tax advisors to determine how a 401(k) plan will fit into your overall financial plan.