401(k) Plan Basics

If you work for a company that sponsors a retirement plan, you should certainly take full advantage of this excellent opportunity to save for retirement on a tax-advantaged basis. But many people are hazy on the details of how various types of plans work. Some even use the terms “pension plan” and “401(k) plan” as if the two were synonymous. While both types of plans are offered and sponsored by employers, there are actually a number of important differences between the two.

Most true pension plans are financed by the employer and are of the “defined benefit” type: that is, the plan guarantees a certain specified pension to be payable for the remainder of the qualified employee’s life, based on age at retirement, number of years of service with the company, amount of earnings, and other variables. Many pension plans are paid 100 percent by the employer, but some may allow contributions by the employee, as well. Typically, the investments in the pension plan are controlled by the employer.

By contrast, 401(k) plans–and the similar 403(b) plan available to employees of tax-exempt organizations like public schools, religious organizations, and some hospital cooperatives–are of the “defined contribution” type. In such plans, the employee and the employer both may make contributions, and those contributions are defined as to the amounts that either employer or employee may make in a given year (in 2017, the contribution limit is $18,000 for individuals under 50 years of age; those over 50 can put in an additional $6,000 due to the IRS “catch-up” provision). The investment of the funds in the 401(k) plan is controlled by the individual who owns the plan.

Since their beginnings in the mid-1980s, these types of plans have become the overwhelming choice of most employers, mainly because they are much less expensive to maintain and administer. They also take away from the employer the risk of guaranteeing future income levels for retiring employees. Instead, it is up to the employee to make sure that sufficient funds are being set aside in the plan to insure adequate income upon retirement.

Advantages to both employer and employee include the ability to reduce taxable income by the amount contributed to the plan, up to the annual limit. Additionally, funds in such plans accumulate on a tax-advantaged basis. Withdrawals from the plan upon qualified retirement age are taxable as ordinary income in the year they are made. Early withdrawals, however, are subject to a penalty, in addition to being treated as ordinary income.

With much higher contribution limits than either the traditional or Roth IRA, 401(k) plans can provide a very useful vehicle for accumulating funds for retirement. Employers who offer 401(k) plans can provide to their employees information about enrollment, investment options, and other plan features and administrative requirements. You may also wish to consult your financial planner or other investment advisor for more personalized perspectives and recommendations.

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