Bits of What You Probably Should Know of 401 (k) Plans
The term 401 (k) is one that is heard quite often in today's. Most people know that it has something to do with retirement, but few young people know exactly how 401 (k) plans work or why they are becoming more and more popular. Additionally, many people who have 401 (k) plans may not know all the details of how they work, how to get the most out of their plan, and how to keep their money safe. In reality, everyone in the business world should be aware of the details and advantages of having and managing a 401 (k) type savings plan, as it is becoming one of the most popular ways to save for retirement in the United States and many other countries.
First, it is imperative to understand the basics of the 401 (k). By definition, a 401(k) plan is an employee funded retirement savings plan that is set up and sponsored by the employer. They are considered individual account plans because each participant's benefit is the value of a separate personal account (401 (k) - Wikipedia). All 401 (k) plans are funded by employee contributions and usually also include matching contributions from the company.
The history of the 401(k) plan begins with an amendment to the Internal Revenue Code (IRC) by Congress which added section 401(k), after which the plan is named. The Revenue Act of 1978 added provisions to the Internal Revenue Code, which included allowing the use of "salary reductions" as a source of plan contributions (McDonnell, 1). Basically, this meant that employees could defer part of their salary into their account, also decreasing their taxable income. The law went into effect in January of 1980 and more regulations were issued in 1981. Shortly thereafter, many companies started the process of adopting 401(k) plans and, by the mid 1980s, nearly half of all large firms already had or were considering 401(k) plans (McDonnell, 1). One of the first companies to begin planning to adopt the 401 (k) even before regulations were issued in 1981 was Johnson & Johnson (Whitehouse, 1). Additional companies that began to develop plan proposals between 1979 and 1982 included, PepsiCo, JC Penney, FMC, Honeywell, and Hughes Aircraft Company (McDonnell, 2).
Interestingly, the 401(k) was originally intended for executives, but quickly became popular with employees on all levels because it had a few notable benefits over the already popular Individual Retirement Accounts (IRAs), which included higher contribution limits, and employer matches (401 (k) - Wikipedia). Over the last twenty years, the 401(k) has grown in popularity and by the end of 2003, had over forty million participants and almost two trillion in total assets (McDonnell, 1). See Fig. 1-1 and 1-2 for 401 (k) growth analyses.
There are maximum contribution limits for 401 (k) plans which are determined by the Internal Revenue Service. For example, the annual limit for 2007 is fifteen thousand dollars, and this limit is evaluated and increased in five hundred dollar increments (The basics of a 401(k) plan). Also, those over fifty years old can make catch up contributions in addition to their normal contributions.
In a normal 401(k) the funds are taken from pre tax salary, and federal income tax is not paid until the money is withdrawn (Neiters). Each type of plan has its own advantages which will be discussed later. There are also strict regulations regarding how and when the money in a 401(k) can be withdrawn. According to the Internal Revenue Service, "distributions of elective deferrals cannot be made until one of the following occurs: the participant reaches age fifty-nine and one half, the participant dies, becomes disabled, or otherwise has a severance from employment, or the plan terminates and no successor defined contribution plan is established or maintained by the employer." The terms of the plan determine whether the distributions are nonperiodic, such as lump-sum distributions...
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