The 401k was enacted into the Internal Revenue code in 1978. Its name is derived from the section of the code that created the plan, subsection 401(k). Generally, a 401k is a retirement plan established by the employer for the benefit of their employees. Employees can choose to participate in the plan by making contributions from their pre or post tax salary.
Whether the contribution is made before or after taxes depends on the type of plan offered by the employer (Traditional 401k or Roth 401k). In the case of a traditional 401k, the employee’s taxable income will be reduced based on the amount of their contribution. The employer may opt to make matching or non-elective contributions to plan on behalf of qualified employees, incentivizing participation in the plan. Employers generally cap the percent of salary contributions made by employees in accordance with IRS regulations.
Earnings on the contributed funds accrue on tax-deferred basis. Taxes are paid upon withdrawal of funds in traditional 401k, or tax free in a Roth 401k where all conditions are met. Employees must meet the minimum age requirement before withdrawing funds in order to avoid penalties for withdrawing funds early. There may also be vesting periods for employer contributions. If a participating employee decides to leave the company before retirement, funds can most likely be rolled over into a traditional IRA without paying penalties.
In choosing whether to participate in a plan, employers and employees must consider the administration and management expenses of different funds. Low management fees are critical to keep the return of the fund high. In accordance with IRS regulations, employers must:
- Establish a prudent process for selecting investment options and service providers;
- Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided;
- Select investment options that are prudent and adequately diversified;
- Disclose plan, investment and fee information to participants to make informed decisions regarding their investment options under the plan; and
- Monitor investment options and service providers once selected to make sure that they continue to be appropriate choices.