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401k Plans - How They Work
A 401(k) is an employee benefit and is sponsored by an employer, usually a private corporation. The corporation is the plan fiduciary and is responsible for drafting and outlining the plan, as well as choosing and keeping an eye on plan investments. (Actually, the majority of employers contract out this work to any one of the various financial services companies, such as a bank, mutual fund company, third party administrator, or insurance company.) An employee voluntarily elects to have a portion of their pre-tax earnings paid directly, or "deferred", into their 401(k) account. If your employer has a trustee-directed 401(k) plan, the employer appoints trustees who decide how the plan's assets will be invested. If it is a participant-directed plan which is more common, the employee has the choice of a number of investment choices, usually a mix of mutual funds that encompass stocks, bonds, and money market investments, or some combination of the above. Some companies' 401(k) plans also offer the opportunity to purchase the company's stock. The employee is allowed to re-allocate money among these investments at any time. If your company does match your employee contributions to some extent, (paying extra money into your 401(k) account in the form of a fixed percentage of wages or profit sharing contributions), these contributions may vest over several years as an inducement to the employee to stay with the employer. (Vesting means having a certain level of service with your company before you can keep their contribution). Choosing a vesting plan allows an employer to selectively reward employees that remain employed for a period of time. In theory, this allows the employer to make greater contributions than would otherwise be prudent, because the money they contribute on behalf of employees goes to the ones they most want to reward. The employer could say that the employee must work with the company for three years or they lose any employer contributed money, which is known as cliff vesting. Or it can choose to have the 20% of the contributions vest each year over five years, known as graduated vesting. Any portion not vested may be forfeited under certain conditions, such as termination of employment. Employees are immediately 100 % vested in their own salary deferred contributions. When an employee leaves the employ of a company, the 401(k) account by and large stays active for the rest of their life. The accounts must begin to be drawn out beginning on April 1st of the calendar year after the calendar year of attainment of age 70½. Also, when an employee leaves a company, the account can be rolled over into an IRA at another financial institution. If the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee may be able to "roll over" the monies into a new 401(k) account offered by the new employer. They would also have the option if they are 59 ½ or older to take their money in a lump sum and pay income tax on it. Another benefit is there are usually no minimums when investing in your 401(k) so you have the option to start small and build on your investment. If your 401(k) investment passes to a named beneficiary and that person is your spouse, he or she will have the same options as you would have to roll it over or cash it out. If they are not your spouse they can not roll it over. The beneficiary will have to take the money either in a lump sum or over a period of years not exceeding their life expectancy.
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