How Each Element of 401k Plan Works
A 401k, or 401(k), plan is an employer's deferred compensation plan allowing eligible employees tax-deferred savings. The money in a 401k comes from elective employee contributions as well as employer contributions. The 401k plan is regulated by the Internal Revenue Service. A 401k plan is different from a SIMPLE 401k, which has its own set of regulations.
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Plan Adoption
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A 401k plan is valid only if it is properly established through an adoption agreement. The agreement must be in writing; all assets are held in trust at a fiduciary company that maintains records of what portion of the assets are for what employee. Employees must have access to information on the 401k plan, what makes someone eligible for the plan and how investments are performing. Eligibility is often based on employee age and time of service.
Contribution Limits
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The 2011 contribution limit allowed into a 401k plan is $49,000 annually. The $49,000 includes all employee and employer contributions. Employees under the age of 50 can contribute up to $16,500 of income. Those 50 years and older are allowed to contribute an extra $5,500. Contribution limits are indexed annually based on inflation. Employer contributions are indexed in $1,000 increments, while employee contributions are indexed in $500 increments.
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Vesting Schedule
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Employer contributions are either matching or non-elective contributions. Employers can match what you contribute up to 6 percent of your annual income. So if you elect to contribute 5 percent of your income, your employer can match 5 percent. But if you contribute 10 percent, your employer can match only up to 6 percent. Non-elective contributions by the employer are not based on the employee contribution. An employer's contribution, whether matching or non-elective, is on a vesting schedule. The vesting schedule determines at what point in time, based on service years, the contributions become yours. Cliff vesting means that you must have put in three years of service until the contributions become yours. With graded vesting, 20 percent of the money in the 401k is yours after one year of service, and then increases by 20 percent each service anniversary. Once money is vested, it cannot be forfeited.
Distributions
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Distributions are funds taken out of the 401k plan. Distributions are taxable; they are added to income. Those not yet 59 1/2 years of age have 10 percent of the distribution added to the taxes as a penalty. There are waivers to the penalty for financial hardships such as possible foreclosure or eviction as well as using funds to pay college expenses or to buy a first home. Loans from a 401k plan are not considered distributions. Loans require no credit qualification and allow 50 percent of vested assets not exceeding $50,000 in loan value. Repaying the loan is done via salary reductions over a five-year period.
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