401(K) Plan - Definition & Meaning
What is 401(K) Plan?
401(k) is a provision of the United States Internal Revenue Code S.401. A 401(k) plan is a tax-qualified retirement savings plan sponsored by the employer.
Employees eligible for the 401(k) plan may make salary reduction contributions on a post-tax and/or a pre-tax basis. The plan is a Defined Contribution Pension plan in which employers may make matching or non-elective contributions on behalf of employees. There are provisions which allow the profit-sharing feature to be added to the plan. The contribution is deducted from the employee’s salary before taxation. The tax is deferred until withdrawn (or methods may vary depending on applicable laws).
Explanation
As per S.401(k) of U.S.-IRC, a 401(k) plan can be offered to employees in a private or a for-profit company.
In a 401(k) plan, because money is deducted from the salary before taxes are withdrawn, the taxable income is lowered i.e. taxes are not applicable on the savings and therefore, taxes are lowered. However, the taxes will be applicable at the time of retirement when the contribution to the plan is withdrawn. Therefore, it is called a tax-deferred plan. However, some plans are designed in such a way that the contributions are made on an after-tax basis. In such cases, the withdrawals are not taxed. There is also an option for the employers to match a portion of the contributions made by the employees to the 401(k) account.
Eligibility –
a) As per law, the employer can delay the eligibility of the plan for up to 1 year.
b) The employee should have completed at least 21 years of age
However, the employer can consult with a legal counsel and reduce the minimum age requirement and/or the minimum period of service requirement
The IRS has limited the maximum pre-tax contribution to $18,000 (as of 2015).
Vesting –
The minimum age to begin withdrawing from the plan is 59.5 years and the maximum age is 70.5 years. However the employee might begin withdrawing from the plan at the age of 55 years if his employment with the employer is terminated or if he is totally disabled.
Joining a new company –
The following options are available to the employee:
a) Carry-forward balance into the new employer’s plan
b) Carry-forward balance into your individual retirements savings account
c) Leave the balance with the previous employer and withdraw contributions on vesting
d) Withdraw the balance (after paying income taxes and early withdrawal penalty)
Examples
|
Example – 1 |
|
|
Annual Salary of the employee |
$50,000 |
|
Contribution of salary to savings % |
15 |
|
Annual contribution amount (Annual savings) |
$7,500 |
|
Taxable income after contribution |
$42,500 |
|
Taxable income in absence of contribution |
$50,000 |
|
Tax % |
40 |
|
Taxes applicable after contribution |
$17,000 |
|
Taxes applicable in absence of contribution |
$20,000 |
|
Tax Savings |
$3,000 |
|
Contribution by the employer (50% of the first 7.5% of salary) |
$1,875 |
|
Contribution by employee to annual savings ($7,500 - $3,000 - $1875 = |
$2,625 |
|
Monthly contribution for the employee |
$218.75 |
|
Example – 2 (without taking tax savings into consideration) |
|
|
Annual Salary of the employee |
$50,000 |
|
Contribution of employee % |
10 |
|
Annual contribution from employee |
$5,000 |
|
Contribution by the employer (50% of the first 7.5% of salary) |
$1,875 |
|
Total Contribution to the 401(k) plan |
$6,875 |
|
Monthly contribution for the employee |
$416.67 |
Hence, this concludes the definition of 401(K) Plan along with its overview.
This article has been researched & authored by the Business Concepts Team. It has been reviewed & published by the MBA Skool Team. The content on MBA Skool has been created for educational & academic purpose only.
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