Investments & Retirement Planning
401(k) PLANS & ROLLOVERS
401(k) Plans TOP
The "401(k) plan," the popular name for a Qualified Cash or Deferred arrangement (CODA) permitted under Section 401(k) of the Internal Revenue Code (IRC), has become one of the most popular types of employer-sponsored retirement plans.
With a 401(k) plan, an employee can elect either to receive cash payments (wages) from his or her employer immediately, or to defer receipt of a portion of that income to the plan. The amount deferred (called an "elective deferral" or "elective contribution" or "pretax contribution") is not currently includable in the employee's income; it is made with pretax dollars. Consequently, the employee's federal taxable income (and federal income tax) that year is reduced. The deferred portion is taxed to the employee when it is withdrawn or distributed.
Example: Assume Melissa is employed by a department store. She earns $30,000 annually. Melissa defers $5,000 of her earnings to the store's 401(k) plan. As a result, Melissa's taxable income is now $25,000. She is not taxed on the deferred money ($5,000) until she receives a distribution or makes a withdrawal.
Roth 401(k) TOP
Beginning in 2006, a 401(k) plan can allow employees to designate all or part of their elective deferrals as qualified Roth 401(k) contributions. Roth 401(k)contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there's no up-front tax benefit, but if certain conditions are met, employees' Roth contributions and earnings are entirely free from federal income tax when distributed from the plan.
Separate accounts must be established within a 401(k) plan (the "Roth
accounts") to track each employee's Roth contributions. Under IRS proposed
regulations, the Roth 401(k) account is treated as a "separate contract"
under the 401(k) plan, requiring separate accounting for the Roth
contributions and any gains or losses on those contributions. The taxation
of distributions from the Roth account is also determined separately from
any other 401(k) plan dollars. (Note: Employers do not have to allow Roth
contributions to their 401(k) plans.) See Roth 401(k) for a detailed
discussion of Roth 401(k) contributions.
Employee Contributions
Whether an employee elects to make pretax contributions or Roth after-tax
contributions to the 401(k) plan, careful attention must be paid to the
elective deferral limits. In 2007, an employee can not contribute more than
$15,500 ($15,000 in 2006) of his or her salary to a 401(k) plan.
Participants who are age 50 or older may also make additional "catch-up"
contributions of up to $5,000 in 2006 and 2007. Other limits also apply.
Employer Contributions
To encourage employee participation, some employers offer to "match" employee contributions under a specific formula. For example, you might decide to match 50 cents on every dollar contributed by employees up to a maximum of 10 percent of each employee's salary. As an employer, you also have the option of making discretionary contributions ("nonelective contributions") to the employees' accounts. These contributions are subject to specific tests to ensure that they don't discriminate in favor of highly compensated employees (see Questions & Answers for the definition of "highly compensated employee").
401(k) Rollovers TOP
A rollover is generally a transfer of assets from a retirement plan maintained by your former employer (it may be possible to roll over certain in-service distributions from an existing employer's profit-sharing plan as well). Rollovers from an employer-sponsored retirement plan can take one of four forms:
- A transfer from your old retirement plan directly to an IRA trustee (this is a type of direct rollover)
- A transfer from your old retirement plan to you, and then, within 60 days, from you to an IRA trustee (this is a type of indirect rollover)
- A transfer from your old retirement plan directly to the trustee of the retirement plan at a new employer (this is a type of direct rollover)
- A transfer from your old retirement plan to you, and then from you to the trustee of a retirement plan at a new employer (this is a type of indirect rollover)
Generally, rollovers come from defined contribution plans. A defined contribution plan is a retirement plan in which contributions are based on a set formula (e.g., a percentage of the employee's pretax compensation), while the payout is based on total contributions and investment performance. The 401(k) plan is the most common type of defined contribution plan.
If a rollover is done properly and all rules are followed, there will be no taxes or penalties imposed on the retirement plan distribution. In addition, a rollover encourages retirement savings by allowing you to continue tax-deferred growth of the funds in the IRA or new plan. When you are eligible for a rollover from your plan, the plan administrator must send you a timely notice explaining your options, the rollover rules, and related tax issues.