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Section 401(k) of the Internal Revenue Code permits employers to set up a trust fund to which an employee may elect to have pre-tax amounts of the employee’s salary contributed to the trust under the plan instead of receiving the amount of salary in cash in order to save for retirement.
What are the Benefits to Participating in a 401(k) Plan?
The funds that an employee elects to contribute to the trust under a 401(k) plan are pre-tax contributions that are not currently taxed to the employee. Instead, such contributions are treated under the tax laws like other employer contributions to a qualified pension plan:
- The contributions are not currently taxed to employees
- The contributions are deductible by the employer at the time the contributions are made to the trust
- The contributions grow tax-free in the plan’s trust fund
- The contributions are subject to favorable tax averaging rules when they are later distributed to employees at retirement
An eligible employee must be given an election to have the employer either make cash payments of the employee’s salary to the employee or make payments of a portion of the employee’s salary on a deferred basis to the trust fund under the 401(k) plan.
Salary Reduction and/or Bonus Payments
An employee’s election to defer must relate either to periodic salary payments or to non-periodic (typically, year-end) bonus payments.
An employee making contributions to 401(k) plans must have a nonforfeitable right to the elective salary deferrals made by the employee pursuant to the employee’s election to defer. This 100% vesting rule also applies to any trust fund earnings on the employee’s elective salary contributions.
Employer matching contributions must vest at 100% after three years of service or at a rate of 20% per year beginning with the second year of service with 100% vesting after six years of service.
Although a 401(k) plan can contain age and service conditions for employee participation in the plan, the period of service required for participation cannot extend beyond the later of the date on which the employee attains age 21 or the date on which the employee completes one year of service. For example, if an employee begins employment at age 18, a 401(k) plan can make the employee wait three years (until the employee is age 21) to first participate in the plan. On the other hand, if an employee begins employment at age 32, the employee can only be required to complete a maximum of one year of service as a precondition to participation in a 401(k) plan.
401(k) plans may not permit employee elective contributions to be distributed merely on the completion of a fixed period of time. Rather, distributions under a 401(k) plan cannot take place until the first of the following events occurs: death, disability, termination of employment, attainment of age 59-1/2 or hardship. Certain other lump sum distributions to employees are permitted in the case of termination of a 401(k) plan, or a corporation’s disposition of its assets or the sale of a subsidiary company.
Limits on Employee Contributions
Elective deferrals by employees under a 401(k) plan are limited to $13,000 (indexed to inflation, the figure in 2008 is $15,500). Any elective contributions in excess of this amount will be taxed to the employee in the year of contribution. The excess will also be taxed again upon withdrawal under certain circumstances.
Questions for Your Attorney
- Is my employer required to match my contributions to the 401(k) plan?
- How do I show hardship if I need to use the money in my 401(k) plan?
- When are my contributions to the 401(k) plan 100% vested?