Getting down to 401(k) basics

When you sign up for a 401(k) plan, you agree to let your employer deposit some of your paycheck into the plan as a pre-tax contribution or as a Roth after-tax contribution or a combination of the two. You put money into your 401(k) plan through a payroll deduction.

Your employer is also permitted to sign you up without your approval, but you have the right to override the percentage you’re automatically enrolled to contribute, including totally opting out. Your employer is required to give you advance notice before automatically enrolling you.

The beauty of a 401(k) is that it makes saving easy and automatic, and you probably won’t even miss the money you put into your retirement account.

I cover the four types of 401(k)s in this book:

• A regular 401(k) is sponsored by your employer. Your 401(k) is funded by contributions deducted from your paycheck and deposited into your account. Check out the chapters in Part 2 for information about regular 401(k)s.
• Several types of 401(k) serve the self-employed and other small business owners. I go into detail about the following plans in Chapter 19:
  • Safe harbor 401(k)
  • Solo 401(k)
  • Qualified automatic contribution arrangement (QACA) 401(k)

Your employer may set up its own 401(k) or adopt one using a pooled plan provider (PPP) to set up a pooled employer plan (PEP) or become part of a multiple-employer plan (MEP). I cover the different rules for these plans in Chapter 19.

Your employer may throw in some extra money known as a matching contribution. You don’t pay federal income tax on any 401(k) money until you withdraw it.

401(k) plans are like snowflakes — each one is unique. If you’re looking for a standard 401(k) plan, be aware that there’s no such animal. Each company creates its own plan, and some are better than others. Part 2 goes into detail about all the aspects of 401(k)s.

Federal laws govern many aspects of 401(k) plans, but employers are allowed to be more restrictive with their plan rules. For example, the contributions your employer allows may be less than what Uncle Sam permits.

The 401(k) gets its memorable name from the section of Internal Revenue Code (IRC) that governs it. Section 401 of the IRC applies to pension, profit sharing, and stock bonus plans.

A 401(k) plan must satisfy the IRC in both form and operation to be a qualified plan. The rules and regulations governing these plans are massive and complex. Fortunately, your employer deals with making sure the plan you’re offered meets IRC standards. You just have to worry about upholding your end of the arrangement, which this book helps you do.

To meet IRC standards, an employer must adopt a lengthy plan document (150 to 175 pages) and have it approved by the Internal Revenue Service (IRS). The document specifies

• Who’s eligible to join the plan
• When they’re eligible
• How much eligible employees may contribute
• The type and amount of any employer contributions
• When the employer contribution belongs to the participant

Each plan’s operation must satisfy all the applicable rules and regulations. This includes legislative requirements enacted by Congress and regulations issued by the governmental agencies that have jurisdiction, which include the Treasury Department, the Department of Labor (DoL), and the Securities and Exchange Commission (SEC). The IRS and DoL conduct audits to determine whether an employer is in full compliance.

Introducing IRAs

An IRA, or individual retirement account, is a tax-advantaged way to save for retirement. This is how the government helps workers save for retirement whenever their employers don’t offer a retirement plan.

This book includes information about all the different types of IRAs:

• Traditional IRA
• Roth IRA
• Spousal IRA
• Rollover/Conduit IRA
• Inherited IRA

Head to Part 3 for details about all these IRAs.

The eligibility rules for a pre-tax traditional IRA depend on whether you or your spouse are covered by an employer-sponsored retirement plan. Otherwise, anyone with earned income can open a traditional IRA. (I cover tax issues and tax terms in Chapter 2.)

With a traditional IRA, you can make contributions on your own anytime up to the date you file your tax return and claim a deduction for your contributions. You don’t get a tax deduction when you contribute to a Roth IRA.

Both a traditional IRA and Roth IRA are invested at a financial institution you select. Your money grows without being taxed with both types of IRA. All withdrawals from a traditional IRA are taxable, and a 10 percent penalty tax is imposed if you withdraw the money prior to age 59½ for any reason other than those that exclude you from the penalty tax. Withdrawals from a Roth IRA aren’t taxable if you follow the rules.

You may be surprised to hear that your author, known as the father of 401(k), thinks there are better alternatives to a 401(k) for solo entrepreneurs, small family businesses, and many other small employers. These IRA-based plans include the following:

• Payroll-deduction IRA
• SEP IRA
• SIMPLE IRA

Chapter 18 includes detailed information about these plans, including why they may be better than a 401(k).

Saving up

From what people have told me over the years, the biggest benefit of participating in a 401(k) plan is that it turns spenders into savers. Most people want to save for the future, but having money left at the end of the month is tough. Saving becomes your priority with a 401(k). You decide how much of your gross pay to put into the plan and live your daily life on what’s left.

These days, it’s easier than ever to transfer a certain amount every week, month, or paycheck to a retirement account, especially if you’re able to participate in a 401(k). Chapters 11 and 12 have pointers for finding ways to save.

You may face a strong temptation to invade your emergency savings when the first significant emergency hits or you see something you really want to buy. Pulling money from a savings account is easy, but getting money out of a 401(k) isn’t easy at all. So, if you want long-term savings immune from impulse buys, go with a 401(k).

If you’re one of the lucky ones, you’re eligible to contribute to both a 401(k) and an IRA. You are probably also eligible to make Roth contributions either inside or outside the 401(k).

Getting employer contributions

Being able to contribute to a plan that has employer contributions is a big benefit of a 401(k) and employer-based IRA plans. For example, if your employer contributes $0.25 for each $1.00 you contribute limited to the first 6 percent of pay that you contribute, you should strive to contribute 6 percent of your pay, so you get the full employer contribution. Of course, if your employer contributes $1 for each $1 you contribute to the 401(k), that’s the best-case scenario regardless of other factors.

Payroll deduction is magical, so take advantage of putting money into a 401(k), a payroll deduction IRA, or a SIMPLE IRA if you have the opportunity. A payroll deduction IRA may include employer matching contributions to encourage employees to contribute. A SIMPLE IRA must include employer contributions. A personal IRA isn’t an effective alternative unless you’re highly disciplined about managing your money.