The Basics of the 401(k): Thoughts from a financial professional

Most often, the first question a prospective employee will ask is about your company’s benefit program. And in my experience, the two most often-asked questions are about health insurance and an employer-sponsored retirement program. Let’s examine the most common employer-sponsored retirement program that exists today – the 401(k) plan.

Background 401(k) plans were named for the section of the Internal Revenue Code in which they are described. They allow employees to contribute their own pre-tax money into a retirement account, often by way of automatic payroll deduction, which is a very powerful tool to help bring discipline to investing for retirement. By investing pre-tax dollars, employees are then able to lower their income taxes in the years they contribute to a 401(k).

In addition to lowering their current year income taxes, employees will not pay taxes on their 401(k) earnings until they withdraw them, usually at retirement.

Because contributions are made on a pre-tax basis, participants generally pay income taxes on their contributions when withdrawals are made – again, this is usually at retirement when they may be in a lower tax bracket. Withdrawals prior to age 59½ may be limited, and if available, may be subject to a 10% early withdrawal penalty. Withdrawals of after-tax contributions will not be taxed.

But is there a match? The question that prospective employees really want to ask is this: does the company contribute to my personal 401(k) at all?

As an employer, you have the option to match some, or all, of your employee’s contributions – which further enhances the employee’s tax-deferred accumulations.

Additional Benefits There are of course many other features that make 401(k) plans attractive. One example is the ability of plan participants (employees) to diversify their contributions in a variety of investment options offered under the plan. These investment options usually include a menu of mutual funds – equity funds, fixed-income funds, balanced funds, money market funds, etc. In addition, most plans allow employees to change how their assets are allocated among the various investment options, giving them the opportunity to create an individualized investment mix that is more in tune with their risk profile.

For example, a 24 year-old employee might choose to invest entirely in equity funds, because he has 30+ years to retirement; whereas a 50-year old employee might opt for a larger allocation to fixed-income funds.

In addition, many plans allow employees to make after-tax contributions (subject to certain limitations). While these contributions would not lower their current year’s income tax, like pre-tax contributions, the employee’s after-tax contributions will still accumulate investment earnings on a tax-deferred basis.

Flexibility: A Part of Every 401(k) Plan

A 401(k) approach could be right for your employees (and your business) if you don’t want to be locked into funding a traditional defined benefit program, which provides a pre-determined benefit when an employee retires.

A 401(k) – in very technical terms – is called a defined contribution plan. This means the plan’s ultimate payout depends on how much the participating employee and your business (if your business so chooses) have paid into the employee’s 401(k) account, in addition to investment income. In other words, a 401(k) enables employees to contribute to their own retirement, while giving your business the flexibility to determine if, and how much, you want it to participate in their plan.

While offering a 401(k) program is a great tool for attracting prospective employees, it can also be used to reward employee loyalty. More specifically, you can establish a “vesting” schedule that specifies when your employees own your employer matching contributions. For example, you might decide that employees will be fully vested after a certain number of years – say 20% per year over five years. Of course employees are always fully vested for their own contributions and investment earnings.

What are the Limitations?

As with all retirement plans, there are certain limitations and they change every year. Also, the contributions of highly compensated employees (HCEs) may be limited if lower paid employees do not contribute a sufficient amount. Each plan year, plan administrators must perform “top-heavy” testing to determine the maximum allowable contribution amount for key employees. So, if you start up a 401(k) plan, make sure you have a strong buy-in from all of your employees.

Summary Although the rules change from year to year and there is an administrative burden in establishing a 401(k) plan for your employees, it may be a worthwhile investment for you and your business overall. Consider hiring a financial professional who can help provide guidance on determining whether a 401(k) plan is appropriate for your business.

Your employees are likely to appreciate that you are helping them save for their retirement.

Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

This article was prepared by RSW Publishing.

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