What Is a 401(K) Plan?

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 Taxes are paid on the contributions when the money is withdrawn.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.

Top 7 Year End Financial Tips

  1. Review investment portfolios for potential tax consequences. Did you own Apple or some other high performing stock this year? Then you might want to take a look at the taxable gains in your portfolio. By selling the underperformers, you can reduce your tax liability from selling some of those high performers. You can even have a net capital gains loss of up to $3,000 (consult your tax professional).
  2. Watch out for taxes on mutual funds. A common mistake investors make is to buy a mutual fund in December. By law, mutual funds must pass any capital gains along to investors before the end of the year. By buying a fund at the wrong time, you could owe taxes on the fund as if you had held it all year long.
  3. Required Minimum Distribution. If you turned 70 ½ before 2007, you must take a minimum distribution from your IRA account by December 31st. Your advisor can help you calculate the amount to be withdrawn.
  4. Giving a gift to a charity. If you have a favorite charity, consider giving the gift of stock instead of cash. Stocks with large capital gains would be an excellent choice. Instead of selling them, you could donate them and avoid paying tax on the appreciation.
  5. Add more to your 401k. To lower your tax bill, you may want to boost your 401(k) contributions, but it is important to make sure you don’t go over the limit.
  6. Pay off those deductible expenses before year’s end. If you pay off your state taxes or property taxes early, that accelerates your federal deductions. You can make an extra mortgage payment (the interest is deductible), or go for that dental work or surgery before year’s end.
  7. Lastly, take this time to get organize. Put together a financial binder with your important documents. Also include the locations of important documents(such as a will, safety deposit box location, bank accounts, etc.) This will make it easier for loved ones to track down documents in case anything should happen to you.