A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.
- Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals).
- Employers can contribute to employees’ accounts.
- Distributions, including earnings, are includible in taxable income at retirement (except for qualified distributions of designated Roth accounts).
Choosing a Retirement Plan: 401(k) Plan
Sometimes it seems as though everyone has a 401(k) plan these days. Did you ever consider getting one yourself but just don’t know how they work?
With a 401(k) plan, employees can choose to defer some of their salary. Instead of receiving that amount in their paycheck, the employee defers, or delays, getting that money. In this case, their deferred money is going into a 401(k) plan sponsored by their employer. This deferred money generally is not taxed until it is distributed.
If you establish a 401(k) plan, you:
- Can have other retirement plans.
- Can be a business of any size.
- Need to annually file a Form 5500.
You can make a 401(k) plan as simple or as complex as you want to. A 401(k) plan that is pre-approved by the IRS might be just the thing to cut down on administrative headaches and expenses.
Pros and Cons:
- Greater flexibility in contributions.
- Employees may contribute more to this plan than under IRA plans.
- Good plan if cash flow is an issue.
- Optional participant loans and hardship withdrawals add flexibility for employees.
- Administrative costs may be higher than under more basic arrangements.
- Need to test that benefits do not discriminate in favor of the highly compensated employees. This testing can be complicated.
- Additional withdrawal and loan flexibility adds administrative burden for the employer.
Who Contributes: Employee salary deferrals and/or Employer contributions. Employees are always 100% vested in their salary deferrals. Employer contributions may be vested on a graduated vesting schedule.
Filing Requirements: Annual filing of Form 5500 is required.
Participant Loans: Permitted.
In-Service Withdrawals: Yes, but subject to possible 10% additional tax if under age 59-1/2.
(Source – IRS Website)