Business Insurance
401(k) Plans
Chapter Ten
In 1978 Congress
passed legislation to encourage Americans to save for their retirement.
Study after study confirms that Americans are among the worst savers on earth (
401(k) plans offer several things:
1. The chance to reduce income taxes.
2. The ability to delay paying taxes on investments.
3. In many cases, 401(k) plans offer free money in the form of employer contributions.
4. The ability to have a better-financed retirement.
Why Would Employers Offer 401(k) Plans?
Some employees will get hired and stay forever, but those who are most in demand will move from one job to another if the pay or benefits are better elsewhere. Employers realize that retirement benefits are one way of keeping good employees with the company. In that context, 401(k) plans may be offered.
Companies offer varying types of retirement programs; some are better than others. Employees seldom have a say in the type of program that is offered, so it is necessary for each worker to take the time to understand what their employer offers. Retirement programs are often called “protective shells.” A protective shell is a program that protects the worker from paying taxes today on money that is put into a program to benefit them at a later date, usually retirement. Taxes may have to be paid at some point, usually as money is withdrawn. There are two primary types of protective shells:
1. Defined Benefit Plans (DBP), and
2. Defined Contributions Plans (DCP).
The key words here are “benefit” and “contribution”. One defines the workers benefit based on a formula and the other defines workers benefits based on the contributions.
Under a defined benefit plan, the worker is promised a specific amount of money when he or she retires based upon the length of service with the company, retirement age, and the amount of money that was earned by the worker. From these three elements a formula is used to determine the amount of retirement income that will be received. The employer will determine how funds are invested. The employer will also keep any gains above the estimated retirement income, and absorb any losses that occur.
Under a defined contribution plan, which includes a 401(k) plan, the worker will be paid based upon three elements:
1. The amount of money that was contributed,
2. The length of time involved (the longer the time, the better returns are likely to be), and
3. The amount of investment return.
In a defined contribution plan, the worker has much more control than he or she would in a defined benefit plan. Many types of protective shells are defined contribution plans: 401(k) plans, money purchase plans, profit, sharing, and individual retirement accounts (IRA). In contrast, a pension plan is a defined benefit plan because the employer determines the amount the individual will receive once they retire.
Various Plans Exist
Most workers lump all kinds of retirement plans into one category: pension plans. However, many types of protective shells are not pension plans (which is why they should be called protective shells instead). The name “protective shell” makes sense: the financial vehicle protects the invested funds from taxation. Once the funds are removed from the protective shells, they are then taxed at the person’s current taxable level.
The confusion is
easily understood. Even employers may refer to their 401(k) plans as
“pensions.” Americans often use the word in a generic sense, considering
pensions to be anything that produces retirement income. Technically
speaking, pension plans and 401(k) plans are governed by different laws, one
coming under DBP laws and the other coming under DCP laws. All
protective shells follow the
While most of us are familiar with 401(k) plans, or have at least heard of them, there are several forms of retirement options:
401(k) Plans
401(k) Plans,
named from the
403(b) Plans
The 403(b) plans are better known as tax-sheltered annuities or tax deferred annuity plans. Non-profit companies are known for offering 403(b) plans, such as hospitals, schools, colleges, and associations. As of 1997, 403(b) plans operate in much the same way as 401(k) plans do.
457 Plans
457 Plans are most often seen in government institutions, some schools systems, and state university systems. Employee contributions are capped so 401(k) plans and 403(b) plans tend to be more advantageous. It is unusual for the employer to match funds in a 457 plan.
SIMPLE 401(k) Plans
SIMPLE stands for Savings Incentive Match Plans for Employees so the letters are always capitalized. Companies with less than 100 employees are most likely to use SIMPLE 401(k) plans. They operate the same as regular 401(k) plans but there is less paperwork and the employer must contribute to the worker’s account. The SIMPLE 401(k) plan was created in 1997 so they are not widespread.
SEP Plans
SEP stands for Simplified Employee Pension so the letters are always capitalized. The self-employed often use SEP plans and appreciate them for their simplicity. SEPs are really just individual retirement accounts that allow employers to contribute on behalf of employees.
Keogh Plans
Keogh plans may also be known as HR 10 plans. They are for self-employed individuals when they constitute both the employer and the employee (one person wearing two hats). Keogh plans allow contribution and tax deductions up to 25 percent of pay to a maximum specified amount. Unlike the SEP plans, Keogh plans can be very complicated.
Why Do We Need 401(k) Plans?
Every agent has probably uttered these words: “No one plans to fail, they simply fail to plan.” This phrase is probably overused because it is so true. When workers were guaranteed a pension through their employer there was less emphasis placed on personal retirement plans. As employers realized how expensive it was to provide retirement funds to workers that continued to live longer and longer, Americans realized that there were no guarantees. Many pension plans suffered financial failures as well.
Americans are among the worst savers in the world. When a worker fails to save adequately for retirement there is seldom any quick fix. Once retirement arrives, if there is too little money available, the only option is to continue working in some capacity or hope family will take on the burden of supporting their poor relatives.
Planning for retirement is actually less about planning and more about doing. It is easy to plan on contributing a percentage of income to a personal retirement plan but it is hard to actually make the contribution consistently over time. That is why payroll deduction works so well for employer sponsored savings plans – the employee never sees the money.
In order for any retirement plan to succeed, there must be a goal. It is often the employer than initiates that goal through work related programs. Agents also play a key role in planning for the future, but usually on an individual basis rather than through a company.
Unfortunately few workers actually take the time to sit down and figure out the amount of money that will be needed in retirement. Most use the “wish, want, hope, and pray” formula: “I wish I had saved something; I want to be able to live as I always have; I hope that will happen by some magical circumstance, and I pray I don’t live too long after the money is gone.”
Those who are able to invest pre-tax income will fare better than those that invest after-tax income. Taxation always makes a difference. It is true that there will be tax due at some point on the savings, but it is likely to be at a lower tax bracket once retirement arrives. There can be exceptions to this. A highly compensated employee may need to invest after-tax money because the amount they could save was capped. It would also make sense to save after-tax dollars to supplement what is already being saved or to save for a short-term specific goal. It will always be true that pre-tax savings is more beneficial than after-tax savings, but that should not prevent a person from saving additional funds.
How does one calculate their needs once retirement comes? While there are many methods of doing so, depending upon the source used, it is really not a difficult equation no matter which worksheet is used.
Retirement Needs Worksheet:
|
Fixed Expenses |
Monthly Current |
Retirement (Estimated) |
|
Mortgage/Rent |
$ |
$ |
|
Property Taxes |
|
|
|
Utilities/Telephone |
|
|
|
Groceries |
|
|
|
Car payment |
|
|
|
Auto Maintenance |
|
|
|
Home/Auto Insurance |
|
|
|
Medical Insurance |
|
|
|
Other Insurance |
|
|
|
Income Taxes |
|
|
|
Personal Expenses |
|
|
|
Credit Card Expenses |
|
|
|
Other |
|
|
|
Variable Expenses |
Monthly Current |
Retirement (Estimated) |
|
Home Maintenance |
$ |
$ |
|
Clothing |
|
|
|
Hobbies |
|
|
|
Gifts/Donations |
|
|
|
Travel |
|
|
|
Long-Term Care Ins. |
|
|
|
Medicare Premiums |
|
|
|
Other |
|
|
|
Total Expenses: |
$ |
$ |
|
Multiply by 12 months to obtain yearly cost: |
$ |
$ |
|
Multiply by years of retirement: |
$ |
$ |
This chart will provide an approximate retirement need. Of course, no one can predict how many years they will live in retirement, but family history can provide a basis to consider. Most people will live at least twenty years in retirement, so multiplying by that amount will be a starting point for those who simply cannot imagine how long they will be retired.
This chart will also provide an idea of when a person can afford to retire. If the chart shows that the participant is extremely short of retirement funds, there may be little that can be done if he or she is already at retirement age. For the younger person, however, it can provide the information necessary to emphasize the importance of boosting the amount that is being routinely saved.
Social Security will play a role in meeting retirement needs. While there is constant discussion of whether or not the program will survive, most people feel it will continue to provide a measure of retirement support. It is important to realize that Social Security income is not sufficient to support an individual. Social Security income should be considered a hedge against inflation, filling in the gaps left by personal savings for retirement. Social Security is a supplement to what one saves for themselves.
Arriving at the amount of money needed in retirement is always an estimate since inflation will certainly play a role in minimizing spending power. The participant will want to factor in a few items: pension funds that will be available, the estimated Social Security that will be available, and any other income that is certain. “Possible” income should not be factored in.
Obtaining the amount of income that will be needed in retirement will depend upon pensions, 401(k) plans, Social Security, and other certain programs that will provide retirement income. Arriving at the rate of savings that is currently necessary will depend upon several elements, including the number of years remaining until retirement, inflation levels, interest earnings on current accounts, guaranteed retirement income from pensions and other financial vehicles, and estimated life span. Any savings that can be accomplished on a pre-tax basis should take priority over vehicles that save on an after-tax basis. This would include the company’s 401(k) plan, since it does invest on a pre-tax basis.
Too Much To Cover in One Chapter
It would be impossible to fully cover the topic of 401(k) plans in a single chapter. Employers are often confused about even their own company 401(k) plans and it is unlikely that an agent will be able to easily solve their confusion.
As we said,
401(k) plans were created by an act of Congress and named for the corresponding
401(k) Plan Elements
Not all 401(k) plans operate in the same manner. While all 401(k) plans will have similarities (because they must follow the law), there can be different features or options available.
Every 401(k) plan will have a plan document. The law requires this to be the case. The plan document is the legal form of the savings plan. It is the plan document that added the word “plan” to 401(k). Because it is a legal document, it can be difficult to read and understand, but that does not lessen its importance. Because it is so important and also so difficult for the layperson to comprehend, the law requires that a 401(k) plan (with the “plan” coming from plan document), also have a summary plan description.
A summary plan description, called SPD, will contain all the elements of the 401(k) plan. It is designed to bridge the complicated language of the plan document so that the employee can understand their benefits.
Every 401(k) plan will have specific individuals who manage it. The exact people involved will depend upon the choices of the 401(k) plan fiduciary. A fiduciary is an individual who is responsible for making decisions about the plan’s operation. Typically, the plan fiduciary will be an employee of the company, but this is not necessarily the case. He or she is required to perform their duties on behalf of the plan’s participants (employees) and their beneficiaries. The fiduciary is required to consider participants in all their decisions, doing what is best for them. He or she cannot make decisions that would be considered careless, foolish, or lacking in logical thinking. The fiduciary must follow the “Prudent Man Rule,” which states that he or she has performed as would a prudent man in the same situation.
The plan sponsor is the owner of the company. It could be someone else if an organization or association sponsored the 401(k) plan but most common are company owners. The sponsor decides to implement the 401(k) plan, designs the plan, and makes the rules that employees must follow. The plan sponsor will be the individual that hires those who operate the plan.
It is the payroll department, under the direction of the plan sponsor, that will deduct the contribution to the 401(k) plan. How often this is done will depend upon how the worker’s contributions were set up. It may be a portion each pay period or once per month.
The plan sponsor has a legal obligation to its participants. He or she must make sure the plan operates according to law. Most employers do a good job, although that is not 100 percent true. In 1995 it was reported by the government that approximately 300 out of the 20,000 plans operating at that time had lost some or all of the employees money to employer fraud. As a result of this study, in 1997 employers were required to invest employee money within 15 business days in the hope that it would minimize future problems. This is not an overly long period of time considering the amount of administrative duties that are involved. Until it is invested, funds are held in Short-Term Income Fund, commonly referred to as a STIF account.
The plan trustee is the person or entity that holds the 401(k) money and safeguards it from harm. The trustee must do what is necessary to keep the money safe, even if the company goes bankrupt. Even though the trustee is hired by and reports to the plan sponsor, he or she must act on behalf of those who have contributed (the employees or participants). The trustee must still follow the trust document in all cases. Some legal documents may refer to the plan trustee as the plan custodian since he or she has custody of the money.
The trustee is often a bank, insurance company, or investment firm. It is their responsibility to safeguard the funds. The trustee invests the money according to the instructions they have received and will keep track of the plan’s assets. They do not keep track of the individual accounts (which is what the record-keeper does), but rather they keep track of the funds as a whole.
Trustees must meet high legal requirements. If the trustee is an individual, then he or she must be bonded, which means having insurance to cover them in case he or she makes a mistake. Trustees of all types carry liability insurance to protect investors from fraud or mistakes. Funds are not protected from investment losses, however.
In most cases, employees direct their own investments (which is one of the reasons 401(k) plans are appreciated by employees). Trustees follow the requests made, even if the choices made are foolish. Trustees bear no liability for the choices participants make. Even if the participants do not have the ability to direct where funds are invested, trustees bear no responsibility for profit or loss.
It is important to note that 401(k) plans are not likely to be insured by the Pension Benefit Guarantee Corporation (PBGC). Because it is a defined contribution plan rather than a defined benefit plan, it does not meet the criteria to be covered by the PBGC.
The plan administrator is the plan’s manager. This person is responsible for the day-to-day administration of the 401(k) plan. The employees go to the administrator when they have a question about their 401(k) plan.
Every 401(k) plan will have a record-keeper who will keep track of the accounts, including buying and selling, borrowing funds, or withdrawing funds, and anything else that affects the funds in the account. The record-keeper is typically the person that sends out reports periodically, usually quarterly.
The investment manager is the fund’s agent. It is the job of the investment manager to make money for those who participate. Of course, there is no guarantee that this will actually happen; some are better at making money than others. The plan sponsor has the job of hiring (and firing) the investment manager. The individual participants have no say in the investment manager, but he or she can voice their concerns to the plan administrator.
The investment manager usually receives 401(k) funds by wire transfer (electronically) from the trustee within a day or two of receiving it from the company. The money will be invested according to the instructions given to the trustee by the record-keeper. While the funds are protected from criminal offenses of the manager they are not protected from investment loss.
Brokerage companies and investment dealers typically belong to the SIPC, which stands for Securities Investors Protection Corporation. It is similar to the FDIC that covers bank deposits. If the money is in a brokerage account it is protected to the legal limits, but it is important to remember that most 401(k) money is not held in a brokerage account; it is held in a trust.
How the 401(k) Plan Works
Not all 401(k) plans are identical, but they will be similar since all must follow the laws pertaining to them.
Eligibility
Most employers do not allow immediate 401(k) plan access to new workers. There is a period of time that must pass before the new worker becomes eligible to join. The exact period of time will vary with the company, but as long as a year’s wait is not uncommon. Additionally, most companies require the worker to be at least 21 years old in order to join. Therefore, a new employee that is 18 years old when hired would have to wait longer than the year’s time to join since he or she would not yet be 21 years old.
It makes sense for a company to require the year’s wait before becoming eligible to participate in the 401(k) plan. If a new employee does not meet the company’s expectations or if the new employee does not like working for the company it is likely that he or she will terminate employment within the first year. Especially if the company matches the employee’s contributions, they want to weed out those that will not stay or that the company will not want to continue employing. No company wants to contribute free money to someone who will not remain with them.
As of 1999 companies can allow someone under the age of 21 or who has worked less than a year for the company to participate. It doesn’t mean they will, but they could elect to do so. The company must still consider whether or not the employee is likely to remain with the company. This is most likely to affect workers who will not receive funds from the employer. If the employer does not contribute to the worker’s 401(k) plan there is no reason to hinder their personal participation.
When the company does not contribute or match the worker’s contributions, it is much more likely that the employee can immediately participate upon employment with the company. If the company does not deposit funds on behalf of the worker, they have nothing to lose if the person leaves the company. Therefore, allowing immediate access to the company’s 401(k) plan is nothing more than paperwork (doing the depositing from the worker’s paycheck).
Full-time salaried employees are nearly always admitted to the company 401(k) plan. Full-time hourly employees are also likely to be admitted once the eligibility time period has been met. Some unions participate in 401(k) plans, but that would only result in most cases from negotiation at contract renewal time.
Part-time workers may be able to join their company’s 401(k) plan, but this will be certainly vary from company-to-company. When the employer does allow part-time workers to join there is nearly always a requirement of hours worked per year (1,000 hours per year, for example).
Contributions
The contribution rate may also be known as the deferral percentage or savings rate. Whatever term is used, it refers to the amount of money the worker contributes to their 401(k) account. This may be done on either a pre-tax or after-tax basis. The contribution is deducted from the worker’s paycheck every pay period. The exact amount that is deducted will depend upon the choices of the worker. For example, the worker may elect to have five percent of his or her total salary deducted and deposited into the 401(k) plan each payday.
The total amount that may be deposited into a 401(k) plan is limited by both the employer and by law. The amount allowed by the employer is often limited for a practical reason: the employer may be matching their worker’s contributions. As a result the employer wants to limit their responsibility. Law limits the pre-tax deposits because the deposits are “pre-tax”. The exact amount of the limitation depends upon the contribution year, since they do change with inflation each year.
Employers typically allow their workers to change their contribution rate each month if they wish to. Making a change is usually required to be in writing, but this is not always the case. Each employer will determine the method they prefer.
Plan Vesting
Plan vesting determines when the company-contributed money is owned by the worker rather than by the company. Of course, any money that the worker contributed is immediately vested (owned by the worker). Vesting would only apply to money contributed by the company on behalf of the employee. Not all companies impose vesting time periods for their contributions; about a third of all companies consider their contributions immediately vested.
There are two common types of vesting: graded vesting and cliff vesting. Graded vesting gives an increasing portion of the money to the employee each year he or she remains with the company. In this way, the employee is rewarded for staying with the company. A graded vesting schedule cannot exceed seven years unless the person works for the government. The minimum that must vest is 20 percent after three years, 40 percent after four years, 60 percent after five years, 80 percent after six years and 100 percent vesting at seven years.
Cliff vesting has no vesting until a specified time period is reached at which time everything is vested. It is an all-or-nothing approach.
In companies that offer a pension plan and a 401(k) plan, vesting may be different between the two. A worker should never assume that what is true for one is true for the other.
Company 401(k) Fund Matching
Although not all companies contribute to their employee’s 401(k) plans, most do according to Watson Wyatt’s 1996 Survey of Defined Contribution Plans. This does not mean that they necessarily match their employee’s contributions, but they contribute at some level.
Some companies do not match what their employee’s contribute but opt to deposit a fixed percentage of the worker’s pay into an account with their name on it. This deposit is most commonly referred to as a profit-sharing contribution. Like 401(k) plans, profit sharing is a protective shell, protecting the employee from paying taxes on the dollar amount deposited. The difference between profit-sharing and 401(k) plans is the employee contribution element: 401(k) plans require the worker to contribute whereas profit-sharing does not.
If the 401(k) plan has a “discretionary” contribution from the employer, the worker may or may not receive a contribution from their employer. As the word indicates, a discretionary employer contribution allows the company to decide from year to year whether or not they will contribute to their employee’s 401(k) plans. This type of 401(k) contribution is nearly always tied to the profitability of the company. Therefore, it gives the employees a stake in the performance of the company. The majority of 401(k) plans are not set up in a discretionary manner.
How the company will pay into a worker’s 401(k) plan may also depend upon the definition used for “compensation.” While most probably use the salary or hourly wage paid, some may include such things as commissions, bonuses, shift differentials, or special awards.
The most common company match is fifty cents on the dollar. In other words, for every dollar the employee deposits into their 401(k) plan, their employer will deposit $.50. There is usually a maximum limit, such as six percent of pay. In other words, if the employee is contributing ten percent of their pay, the employer would only contribute up to six percent of the pay, disregarding the other four percent of the worker’s contribution.
401(k) Loans
Most 401(k) plans allow loans to be made on the funds. That does not mean the option should be used. The money is deposited into the account on a pre-tax basis, meaning the employee did not have to pay the government anything. Once it is borrowed, even though the employee repays the loan, the repayment is made with after-tax dollars. Tax will again be paid at retirement when the funds are withdrawn. It will not matter to Uncle Sam that part of the money was already taxed when the loan was repaid. Whatever amount was borrowed and repaid will be taxed twice – when repaid and again when it is withdrawn at retirement.
Money borrowed from a 401(k) plan is the same as borrowing from oneself. The worker already owns the money, so when he or she “borrows” from their account, he or she is actually using their own money, but paying tax on it twice.
While there will be variances, most workers will be required to complete a legal document called a promissory note relating to the loan. It will state the amount of the loan, the interest rate charged, and the loan’s term. The worker can usually pay it off in full, but not necessarily be allowed to simply make larger principle payments. That is because of the extra work involved in adjusting balances. Most 401(k) loans allow only the specified payments to be made or payment of the balance in its entirety. Often loan payments are taken directly from the worker’s paycheck. The interest charged is often the prime rate plus one percent. The prime rate is the rate banks charge their best customers.
Most 401(k) plans allow the participants to borrow up to half of their account balance, up to a ceiling that is specified. Law governs the maximum amount that may be borrowed. Most plans allow only one loan at a time, even if the maximum amount has not yet been borrowed. Most plans have a minimum loan amount as well, usually $1,000. The plan administrators do not want to have the plan turned into a “payday account” where workers are using it merely to meet short term needs until their next paycheck. Loans must be repaid within five years. Money that is not vested cannot be borrowed. Employers may restrict how money is borrowed.
For the married participant, he or she may be required to have their spouse sign off on the loan from a 401(k) plan. This is called spousal consent. The spouse is not cosigning for the loan, he or she is merely agreeing to the loan.
If a loan is used to purchase a primary residence then the five-year repayment period does not apply. Primary residence loans can extend to ten, fifteen, or even twenty years.
Processing loans will cost the employer money. As a result, many small companies do not even allow it. When they do, they must pass on these costs to the borrowers in the form of various fees. Many 401(k) plans charge a loan fee of $25 to $100. Additionally, there may be administrative fees that are levied yearly. If the worker is borrowing small amounts, these fees may not justify taking out the loan. These fees do not go to the employer. They go to the record-keeper to offset the extra work and expenses of the loans. It should be noted that although the worker is borrowing his or her own money, their loan agreement is with the plan trustee.
It is important to remember that 401(k) plans do not necessarily reflect the desires of the workers; it will reflect the desires of the employer. Often loan features are allowed because it will attract more workers to join the plan. Unfortunately, many workers want access to their money prior to retirement. Highly compensated employees are limited to how much of their salary they can contribute by the amount of dollars the non-highly compensated employee contributes. Therefore, if the non-highly paid workers are not utilizing the company’s 401(k) plan, it affects those who most want to use it.
Not all participants in 401(k) plans can borrow funds from their account. Shareholder-employees of S-Corporations, partners, and sole proprietors are not eligible to borrow from a 401(k) plan even though the plan allows for borrowing for their employee participants.
It should be noted by any worker thinking about taking a loan that there is what is referred to as an “opportunity cost” associated with it. That means that money removed from the account loses the opportunity to increase the fund’s size. Why? The amount of money withdrawn is not available to earn interest for the account. Additionally the loan is repaid with after-tax dollars. As previously stated, taxes will again be levied at retirement when funds are withdrawn. Therefore, the loan amount becomes twice taxed.
What happens if
the borrower defaults, not repaying the loan? Loans are governed by
Loan requirements will depend upon the 401(k) plan. While all must follow the law, they are allowed to restrict how loans may be taken. Some employers limit loans to specific purposes, such as education or medical expenses. These types of loan limitations are often called hardship loans because they are only available for hardships.
Fund Withdrawals
401(k) plans are
intended for retirement. Even so, the Internal Revenue Service (
1. Hardship. Exactly what constitutes a hardship may vary but usually it includes:
a. Education. Education expenses for the worker, his or her spouse and their children.
b. Eviction. To prevent being evicted from a rental home, loan funds are usually available.
c. Primary Home Purchase. A loan may usually be taken to buy a home, condo, or mobile home if it will be the primary residence of the worker.
d. Medical Expenses. These expenses would be ones that are not covered by a medical policy obtained privately or through work.
2.
3.
In-Service. This allows
the worker to withdraw their funds for any reason, but it will mean paying
taxes on it and possibly being assessed the 10 percent penalty fee for early
withdrawal levied by
4. After-Tax money. If money has been deposited into the 401(k) plan with after-tax dollars, it may be possible to withdraw those funds.
In-Service options are included in less than half of the 401(k) plans. It allows workers to contribute additional after-tax money into their 401(k) accounts. Employees like this option because they enjoy having access to their funds. It is important to realize that employers do not have to allow this option.
Employers also do not have to allow funds to be withdrawn at age 59 ½. Companies who previously offered in-service and age withdrawals are changing their rules, no longer allowing it. The reason most often given is the administrative costs associated with it.
It is not always necessary to withdraw funds even in times of hardship. If a participant files bankruptcy, for example, creditors cannot force the individual to withdraw or borrow funds from their 401(k) plan. Nor can the creditor attach the 401(k) plan funds. Money in accounts like 401(k) plans has special protection. Federal law prohibits what is called “alienation of benefits.” The point of this law is to prevent money earmarked for retirement from being used in inappropriate ways. Since the plan is designed for retirement, it is seldom advisable to use it to pay debts of any kind. This law has protected millions of people from losing their retirement funds even when they have made bad financial decisions, like overspending on credit cards.
Funds in a 401(k) plan can be diverted in a divorce. In order for the divorcing spouse to receive a portion of a 401(k) plan, he or she would request a qualified domestic relations order, called a QDRO. This is a judgment (order) from the court requiring a portion of the 401(k) plan be set aside for a particular purpose. The purpose can include alimony, child support, settlement of property disputes, or other reasons the court would honor.
In some states, known as community property states, 401(k) plans are considered jointly owned by a legally married couple, even if only one of the two contributed to it. In community property states 401(k) plans become part of the marital assets that must be divided during a divorce. The participant will not be asked to give them up; instead the court will go directly to the plan trustee and request them.
A 401(k) plan that has been awarded in a divorce will be treated differently than it otherwise would have. The former spouse may take the funds, leave them to accumulate, or roll them into a different vehicle or their own 401(k) plan if they have one. Taking it as a lump sum is often chosen, but this will trigger taxes since the funds have not been previously taxed. There will be no penalty even if the former spouse is younger than 59 ½. Leaving the funds where they are will depend upon the courts and the plan document. If the funds may be left, no taxes will need to be paid since the funds have not been withdrawn. Most professionals, however, would suggest rolling the 401(k) funds into an IRA. No taxes will be due until distribution occurs and an IRA offers many varied investment choices.
If the recipient of the plan is a child or dependent, he or she may not roll the proceeds into an IRA. That ability is only given to spouses. Taxes will be due on the distribution but they will not be levied against the dependent. The 401(k) owner will be assessed the taxes even if the distribution was ordered by the courts.
A legally married spouse does not have access to the 401(k) plan while the legal owner is alive. Although the spouse is typically the designated beneficiary, he or she can only have access to the funds following their spouse’s death.
Americans do not tend to remain with the same employer throughout their working life. When the worker changes jobs, he or she must make some decisions regarding their retirement plan. If the balance in the 401(k) plan is sufficient it may be able to remain where it is. The employer must continue to maintain the account, but the terminated worker will not be allowed to make any additional contributions or take any new loans.
If the new job also has a 401(k) plan the worker will likely be able to move the funds from the previous job’s 401(k) plan to the new employer’s 401(k) plan. The worker should avoid having a check sent directly to him or her. Rather, have the funds transferred directly to the new 401(k) plan. This is as easy as filling out a form and having the plan trustee execute the transfer. Since this is not a distribution, no taxes or penalties will be levied.
A worker who is terminated or leaves a job can transfer the 401(k) funds even if there is not another similar plan available. The funds can be transferred into an IRA (individual retirement account). This vehicle is known as a conduit IRA. Again, the funds should not be sent to the participant. They should be transferred directly into the account set up to receive them. This can be accomplished by filling out a rollover application. The trustee of the conduit IRA should receive the 401(k) funds directly from that plan’s trustee. Again, since this is not a distribution, no taxes or penalties will be levied. If these funds are kept separated from all other IRAs and no contributions are added, it will preserve the right to roll into a 401(k) plan that might be available in the future. It is very important that the 401(k) funds not be commingled. No other money should be mixed with these funds.
Section 72(t)
Owners of
individual retirement accounts and 403(b) accounts are eligible at any time for
any reason to make periodic distributions based upon
For an older, unemployed person this may prevent financial ruin. Once five years has passed or the recipient reaches age 59 ½, he or she can stop the payments if they wish until age 70 ½ is reached, at which time mandatory distributions will begin.
If a worker is
unemployed at age 50, he or she may also begin taking distributions from their
401(k) plan without penalty. Law allows a person who is 50 and unemployed
to begin withdrawing money without paying the 10 percent
Non-Discrimination Testing
When 401(k)
plans were first established by Congress, there was concern that only highly
paid employees would be allowed to participate. Therefore, Congress gave
the
Although this was aimed at protecting lower paid employees, it actually affects those that are highly paid. Employees that earn above the established limit may find they are limited in how much they can deposit or have contributed for them.
There are “safe harbors” in the requirements that allow employers to bypass the testing. Non-discrimination testing is complex and has not been fully evaluated here. Those dealing with 401(k) plans must fully understand all aspects of this and will want to investigate further.
The
401(k) Plan Investing Options
Seldom does anyone we know actually find a “get rich quick” investment. For most people, it is a “get rich slow” process. It takes time and commitment to a savings program to reach a comfortable level of retirement living.
While 401(k) plans will vary in their investment options, most will fall into one of three major investment categories, which may be referred to as investment objectives or asset classes.
1. Investing for safety.
2. Investing for income.
3. Investing for growth.
When the participant invests for safety, he or she is probably at an age where financial loss cannot be tolerated because there is no time to make up those losses. This person wants investments that contain very little investment risk. It must be noted that such secure investments do not grow as fast as those with higher risk. When this person invests for safety, he or she could be risking income and growth potential. Interest earnings will be proportionate to risk. Annuities are often the vehicle of choice for those who want guaranteed security. Of course, there is no investment that is 100 percent guaranteed secure. Even loss by inflation is an investment risk.
Participants that invest for income are often at the gates of retirement and need to know that there will be income waiting for them on regular intervals, often monthly or quarterly. The individual investing for income risks safety and growth. As we know, it not possible to have everything in an investment.
The investor looking for growth is often younger with time on their side. Time is the nourishment of growth. That is why those who begin saving at younger ages do not have to work so hard at accomplishing their goals; time is their ally. Those investing for growth may sacrifice safety and income.
Risk affects all types of investments. There is no such thing as a risk-free investment. Whether the risk comes from market risk or inflation makes little difference since the role of all risk is to reduce the end result. Of course, it is possible to minimize risk just as it is possible to increase risk.
Some types of investments carry low rates of risk. These are often called cash equivalents because they are mostly safe from stock market risk. Such investments would include an individual’s checking and savings account at the local bank, certificates of deposit, and treasure bills. Cash equivalents are also liquid forms of investments because the cash in them is easily obtainable.
Many investors report that they do not feel comfortable choosing where to invest their 401(k) funds. Larger sized companies may have an individual employed to assist their employees, but this is not always true. Individuals need to earn enough to accrue sufficient funds for retirement while preventing investment loss if possible. Reaching the retirement goal will depend upon several factors, including the time period involved (little time means little savings). When investing in stocks short-term swings are inevitable and should not be alarming to the investor. Short-term risk, called market risk, is the possibility of losing part of the investment due to market declines.
Retirees are bound to experience inflation risk at some point. Inflation risk is the possibility that their money will buy less when they spend it than it would have when they saved it.
Most professionals group risk into one of four categories:
1. Interest rate risk: the risk that interest rates will change keeping the investment earning less than it otherwise could have.
2. Business risk: the risk that an industry or company will do poorly making the investment perform below expectations.
3. Credit risk: the risk that a borrower is not able to pay back the interest or principal that was due on a loan.
4. Liquidity risk: the risk that immediate funds may be needed, which is not available from the investment.
Most investments involve time. While there are short-term investments, if the participant is planning for retirement, it is likely that long-term investments will best meet his or her long-term goals. Some types of investments simply do not perform well short-term. Many of the top investment professionals feel that stocks held for a minimum of five years are the best performers.
An advantage of saving through a 401(k) plan is the methodical way funds are saved. When stocks are purchased on a scheduled basis over time it is referred to as dollar cost averaging. This merely means that the investor continually deposits into the account in good times and bad. When stocks are purchased, some deposits will buy more stock than others based on current pricing. Over time, it is likely that more stock will be purchased than would have been if purchased all at once.
Fund Rollovers
Although we have briefly mentioned 401(k) plan rollovers, they are worth giving extra attention. A rollover is a tax-free transfer of money from one program to another. Many types of retirement plans utilize rollovers. Usually the vehicle must be moved to a similar type of vehicle to maintain its tax-sheltered status. If properly executed, no tax or penalty is levied. Ideally, the transferred funds should never touch the investors hands, going instead directly from one plan trustee to another. When rolling funds from one program to another, assumptions should never be made. If the facts are not clear, advice should be sought from a qualified person, such as a tax attorney or accountant.
Most rollovers are very simple. Forms are filled out and trustees transfer funds. When funds are transferred from trustee to trustee it is called a direct rollover. It may also be called a trustee-to-trustee transfer. In this kind of transfer the participant does not handle the money.
If funds are sent to the plan participant rather than to another trustee, some rules apply. By law, the plan trustee was required to withhold 20 percent of the funds to cover any taxes that would be due if not deposited into another retirement fund. The deposit into a similar fund must be made within sixty days to avoid taxes and possibly a ten percent penalty as well. When the funds travel through the participant’s hands, it is called a regular rollover.
Direct rollovers carry some advantages:
1. There is no worry about taxation if the transfer is properly executed.
2. The funds continue to be tax-sheltered so that income continues at the best level available.
3.
It avoids the ten percent
4. When funds are transferred trustee-to-trustee it is not necessary to withhold 20 percent from the lump sum since there is no danger that the money will not be re-deposited.
To recap, a direct rollover does not touch the hands of the
participant. The funds transfer from trustee to trustee. A regular rollover does touch the participant’s
hands. If the participant is diligent in re-depositing the funds all is
well, but if he or she does not appropriately re-deposit the funds there will
be taxes due and possibly penalties levied by the
The
The question
must be asked: if 20 percent is withheld, how does
one actually redeposit the entire amount in the appropriate manner in the time
allowed? This question highlights the great disadvantage of
the regular rollover. If the participant is not able to redeposit the
entire amount (including the 20 percent that was withheld by the
Why would a participant choose a regular rollover over a direct rollover? Perhaps he or she is not sure what they want to do when they change jobs or perhaps they think they may need the money. Perhaps the most likely reason is not necessarily that the participant chose a regular rollover, but rather that he or she did not understand what they were requesting when they requested it. Whatever the reason, if it can be avoided it should be.
Rollovers cannot be performed on a whim. They must meet specific criteria. Usually 401(k) funds can be rolled when employment ends, the participant becomes disabled, or the participant retires. A surviving spouse can roll the funds but only to an IRA.
Some funds can be rolled, but not necessarily all of them. If a loan has been taken but not repaid, those funds cannot be rolled because they are not actually in the plan (they’ve been removed in the form of a loan). Any type of withdrawal that has not been repaid cannot be rolled to another account. This would include hardship withdrawals and any distributions considered “deemed distributions.” These are outstanding loan balances that exist when the participant leaves their employment. Since the individual has left the company it is not possible to repay the loan, so the funds are considered a payment to the participant.
Otherwise, all pretax contributions and their investment earnings may be rolled into another 401(k) plan or some like vehicle. Contributions made by the employer that is fully vested and the earnings on those vested funds may be rolled. Any funds in the current 401(k) plan that were previously rolled from another account can be rolled again to the new plan. Distributions from pension plans and employee stock ownership plans (ESOP) can also be rolled. Payment must be a lump sum from one account to the other (it is not possible to make payments from one tax sheltered account to another). Some types of pension plans allow for periodic payments to the participant, but rollovers must always be performed as a lump-sum transfer. Even if this was allowed, employers do not want partial amounts moved. Either everything must be left where it is or the entire amount must be moved.
It is possible
to roll only a portion of the 401(k) funds to another plan, keeping some of the
money as a distribution. Of course, taxes will apply and if the
distribution is taken early, so will the 10 percent
In the past, some employers gave company stock rather than cash as their contribution to the 401(k) plan. If the company distributes shares of company stock rather than cash it may not be possible to roll it into another 401(k) plan. New 401(k) plans are not willing to accept stock as a rollover. Neither will most financial institutions. Some brokerage firms may do so. If the company issues only stock, it may be best to sell them or get the company to accept them back and issue cash instead.
As long as the account contains the minimum amount required by law, it must be stressed that it is not necessary to move the 401(k) funds just because the participant left the company. If no other 401(k) plan is available it might be worthwhile leaving them where they are. Of course, it will not be possible to make additional contributions. If the balance in the account meets legal requirements, the law requires that participants be allowed to leave their money in the 401(k) plan even if they leave the company or are fired. If the balance is below legal requirements, it may be necessary to move the money elsewhere. If the money must be moved and no other 401(k) is available, an IRA is the likely alternative. Most professionals feel it is best to use a conduit IRA and keep the money separate just in case a future employer offers a 401(k) plan.
At Retirement
When retirement arrives, the 401(k) plan participant will be deciding how to use their funds. Depending upon the plan provisions, the worker may be required to transfer the funds elsewhere. On the other hand, the plan may allow the worker to leave the funds where they are even after retirement. If the worker does not yet need the money to live on, this may be an excellent choice since the funds will continue to grow on a tax-sheltered basis. As we have said, there is no tax liability until funds are withdrawn. Sometimes, participants need to wait until the most favorable opportunity before withdrawing them and paying taxes. Normally, 401(k) funds must begin being withdrawn by age 70 ½, but this is not always the case, especially if the individual is still employed. Fund distributions must begin no later than April 1st after the year in which the participant retires.
Many 401(k) plan participants transfer their funds into an annuity, in order to receive a series of payments meant to last their lifetime or the lifetime of both them and their spouse. For those who do not want to continue making investment choices, this may be a good decision. While an annuity will provide lifetime income, it is important to realize that it will not guard against inflation. Once annuity payments are established they remain constant, with no regard for rising costs of living.
It is also possible to roll the money into an IRA from the 401(k) plan. Many IRAs are very similar in their investment strategy to the 401(k) plan, so this may be ideal. It is even possible that the same company that handled the investments for the 401(k) plan has an IRA that will perform nearly the same.
Some 401(k)
participants choose to take their money as a lump sum. While this may
work well for some, it is not advisable for many since it could trigger a large
tax liability. Of course, the
Whatever is
selected as a payout, it is very important that it be completed on time.
Withdrawals from qualified retirement plans must begin by April 1 of the year
following the year the participant reaches age 70 ½, except in specific
circumstances. If this is not done, the
In Conclusion
Professional money managers have traditionally suggested that a retiree will need 80 percent of their working income once retirement is reached. In the past few years that figure is being reconsidered. We are seeing many additional needs that weren’t previously recognized. Why has the thinking changed?
Money managers are seeing two major changes in the lives of those who retire today over those who retired ten or twenty years ago. First of all, retirees are more active than ever before, traveling and enjoying many types of hobbies that are often expensive. Secondly, the cost of medical care has greatly increased. Where many retirees formerly had medical coverage through the company they retired for, today we are seeing that benefit disappearing.
Medical coverage in retirement may be more than a Medicare supplemental policy to go along with Medicare medical benefits. As we know, Medicare covers only hospitalization and outpatient doctor visits. Although there are some recent additions to help with prescription drugs, it is not yet known if this will be adequate. Prescription drugs can be a major cost in retirement.
There is another major cost of retirement: the possibility that a nursing home confinement may be necessary. Individuals who did a great deal of planning and saving have been wiped out financially when they or their spouse entered a nursing home for an extended period. While today’s citizens are much more aware of this possibility it doesn’t mean that they are any better prepared for it. Long-term care policies are expensive. Many geographical areas have seen the premiums for this type of policy skyrocket. Those who previously bought a policy have seen the cost surpass their ability to keep it.
Ideally, there should be a nursing home policy place that was purchased at a young enough age to keep premium costs affordable. If such a policy is considered at older ages, costs are much higher. Additionally, underwriting requirements may make purchase at later ages impossible if health conditions exist. If no assets need protection, then a long-term care policy may not be necessary.
This brings us back to the need for planning and spending control. If a retiree will need more than 80 percent of their working income, is it possible to save that much while still living a comfortable life? This question brings us back to the importance of time. It is far easier to save adequately when there is time available for the compounding of interest. Those who wait until later years must save far more to receive the same benefit.
Americans are spenders by nature. Perhaps we are an optimistic group of people, believing that everything will always work out. It is more likely, however, that we simply lack the discipline necessary to save adequately for our retirement. We prefer to spend. Because this seems to be the case, the need for company sponsored plans like the 401(k) plans, is vital. When payroll deduction can take the money out of our sight, we are far more likely to save for retirement. If we must do it on our own, we seem to have great difficulty achieving success.
Thank you,
United Insurance Educators, Inc.
End of Chapter Ten