There are many reasons for the popularity of 401(k) plans, but the one reason which employees appreciate the most is their personal involvement. In older types of retirement plans the company made all the decisions.
Now the employee decides –
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First, by electing to defer salary pre-tax which is deposited into your 401(k).
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Second, by choosing investments, among those offered by the Plan, to tailor your 401(k) Plan to meet your personal objectives.
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Third, by allowing daily access to your account to monitor your investments.
Also the tax advantages allow you to save more –
- 401(k)
plans are named after the IRS Code Section 401(k),
which allows for voluntary pre-tax savings. This means that you
don’t pay federal and state tax on the money
you contribute to the plan.
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The investment earnings accumulate tax deferred, as with all other types of IRS qualified plans, until paid out at retirement.
Lastly, companies can, but are not obligated to make additional contributions on your behalf –
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Some companies match the contributions of their employees. Usually this match is a portion of what the employee contributes up to a certain level.
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Some companies also contribute additional amounts called profit sharing contributions. These contributions are made regardless of how much, if any, their employees contribute and are allocated based on salary.
401(k) plans are the plan of choice for both companies and their employees due to the tax advantages and personal involvement on which they are based.
TAXES!
Both the federal and state governments will reduce your taxes if you save in the 401(k) plan. This initial tax savings allows you to save more because the government “chips in” by deferring your taxes. The investment earnings also grow tax-deferred unlike your personal savings.
Let’s look at an example. If you are paying 20% in federal and state taxes, the government “chips in” by reducing your taxes by 20¢ for each dollar you save.
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 |
 |
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| Saving on your own | $1.00 | 20¢ | 80¢ |
| Saving in 401(k) plan | $1.00 | N/A | $1.00 |
The advantage is clear – by not paying taxes you have more money invested to earn more money for you. This brings to mind the old saying: “let your money work for you, rather than, you working for your money!”
A profit sharing plan allows a company to make additional contributions for their employees. These profit sharing contributions, sometimes called employer discretionary contributions, are usually distributed or allocated to the employees proportional to their salary.
A 401(k) is a feature under the umbrella of a profit sharing plan. Therefore, an IRS qualified profit sharing plan is required before you can have this 401(k) feature. However, the discretionary contributions are optional. This sometimes causes confusion. The 401(k) feature allows employees to voluntary contribute a percentage of their salary on a pre-tax basis. 401(k)’s also allow your employer to match a portion of the amount you contribute, but this is also optional.
The Employee Retirement Income Security Act (ERISA) was established to protect the rights of employees in retirement plans. All of the funds that are invested for your benefit must be held in trust and are separate from your company’s assets. This means that all of the money in your account must be held in a separate Trust for your benefit. Because the money is held in trust, it is protected from the company’s creditors if it goes out of business.
If your company is sold, your new company could take over the responsibility under ERISA to protect your account. Alternatively, in some company sales situations, the 401(k) Plan can be terminated and the plan assets distributed. Also, if your company goes out of business the Plan is usually terminated. If a 401(k) plan is terminated you are allowed to receive a distribution or directly rollover your account to your own Individual Retirement Account or your new company’s Plan.