What exactly are 401k plans? A 401k plan is a type of an employer sponsored retirement plan for the employees of the organization. The plans are generally grouped into 2 main categories: defined benefit and defined contribution plans. In the case of the defined benefit plan, the employer promises to pay the retired employee a defined amount as agreed after the employee fulfils the required eligibility and criteria. Under the defined benefit scheme, the retired employee continues to receive monthly benefits from the employer after meeting the required criteria. The benefits of the plans are linked to the services rendered by the employee in the organization and also based on the final average salary calculated by the company. The employee can fully trust the benefits offered by the plans, but the only disadvantage is that protection against post- separation inflation is usually limited. Until recently the defined benefit plan was the most favored plan by employers in organizations.
In the case of defined contribution plans, the plan defines only the contributions that the employer can make. It does not mention the benefit In advance and hence the retirement outcomes are also not known in advance. Employee’s 401k contributions are automatically debited to their accounts or deducted from their monthly paycheck. Also, the money taken out before the employee’s paycheck is taxed.
The best advantage of the 401k plans is that any business whether it is a huge organization or a sole proprietorship can go in for the plan. The top management of the company defines the guidelines at the time of the plan being established in the organization. The employees have to fulfill certain eligibility criteria for being a part of the plan. The organization has full right to exclude certain people from the plan like part time workers and union members. The contributions to the plan can come from the voluntary amount deduction from the paycheck of the employees and also from the employer if he is willing to make a contribution. The employees are immediately 100% vested with their own salary deduction tax deferred contributions.
The employee withdrawals from the plan before the age of 59 and half years are liable to 10% penalty. However the employees who retire anytime before the calendar year in which they attain the age of 55 or later are not subject to tax liability. The employer is not under any obligation to make any contribution to the 401 k plan, nut under certain circumstances the employer is advised to make a contribution towards the plan. One such case is when the plan is deemed top heavy. Also with the normal plans, turnkey and internet plans are also available. There is excellent range of investment options available for the plan sponsor. An average 401k plan has about 15 options on an average to choose from. The participants can stop contributing to the plan during the course of the year, as determined by the company. The vendor selected by the plan sponsor is responsible for making reports, doing accounting and testing of the plans.
We see how the 401k plans are useful for the employees and help them later in their retirement years.
S. Stammberger is the editor of 401K
Power Plans. 401k Plans Explained.