History of pensions and 401Ks - Pensions became a common benefit to reduce hiring costs and encourage employees to stay with their company for the entirety of their lives. Pensions were became a common benefit and were guaranteed for life.
Traditional pension plans are called “defined benefit plans”. These plans were solely funded by the employers. This was based on how much they earned, how long they worked, and other criteria. They were promised a set benefit for life when their employees retired.
Eventually the cost outweighed the benefit. Many companies began opting out of pension plans and started choosing defined contribution plans (401k) or went out of business. People were losing their pensions when the companies they once worked for went out of business or was replaced by 401(k)s.
Pensions are rare today but can still be found in some industries like education, government jobs, health care, and in a few corporations.
In 1974 President Ford signed into law the Employee Retirement Income Security Act (ERISA). ERISA was an insurance protection program established to protect pensions. It set up the Pension Benefit Guaranty Corporation. This was done to safeguard pensions.
The closest things we have to a pension plan today are Social Security and annuities Due.com has lots of detailed information on pension plans and 401k’s https://due.com/pension/the-history-of-the-pension-plan/
There are many kinds of 401(k) plans. Below is a list in order of what is the most common to the least common:
1. Traditional 401(k)
This is the most common of the 401(k)s and they are tax-deferred. The money is deducted prior to taxes. Contributions to the 401(k) are made by the employee each pay period and are usually deducted through their payroll.
Different 401(k) packages are offered to the employee. The employee chooses a package based on their risk tolerance. Most of the time these investments consist of mutual funds.
Holders won’t have to pay taxes on these accounts until after they are retired.
401(k) Contributions
The maximum an employee can contribute to their 401(k)is determined by the IRS. Since the cost of living increases each year, there is also an increase in the contribution allowed. They are updated on the IRS government website https://www.irs.gov you can go to the search bar and type in contribution limits for the updates.
Employers can also make matching contributions. Each employer is different so you would have to check how much your employer contributes. For those over 50, they can pay more known as “catch up contributions”.
Withdrawals, Penalties, and Exceptions
Upon retirement, withdrawals from this account are taxed as ordinary income. Anything withdrawn prior to age 59 ½ could be subject to penalties. There are some exceptions where you won’t be penalized:
- disability
- health insurance premiums after 12 weeks of unemployment
- unreimbursed medical bills
- the death of the account holder to beneficiaries
- higher education
- first time home buyer
- If you owe money to the IRS
- Sometimes for income purposes but there are many caveats to this.
- 59½ without paying tax penalties. There are, however, some exceptions to that rule 9
Once you are retired the 401(k) requires minimum distributions (RMD’s). RMD’s are different for everyone. It is best to use Publication 590-B that you can get from the IRS. The tables and charts can help you calculate your RMD amount. I have also found that the institution your account is housed with will also tell you what your distribution should be.
2. Roth 401(k)
Also known as a designated Roth account The Roth 401(k), sometimes called a designated Roth account, This works in reverse. The investment into the Roth 401(k) is made after taxes are paid. These become tax free upon withdrawal at 59 ½ and if they had the account open for at least 5 years.
If your employer offers this and you think you will be in a higher tax bracket when you retire this may be the better option. In some cases, if your employer offers both you may be able to split investments between the two accounts.
Roth 401(k)s are no longer subject to the RMD’s as of 2024.
3. SIMPLE 401(k)
The word SIMPLE is actually an acronym for “Savings Incentive Match Plan for Employees. Are designed for small businesses that have less than 100 employees.
With this plan employees can contribute up to $16,000 in 2024. For those older than 50 it is $19,000. Upon retirement the money is taxed the same way as a traditional 401(k).
The employer is required make a matching contribution of up to 3% or they can do a nonelective contribution of 2%. A nonelective contribution is when an employer elects to contribute regardless of whether or not the employee contributes.
Like the traditional Roth 401(k) and SIMPLE 401(k), they can be subject to penalties if withdrawn prior to age 59½ and if you do not take the required minimum distributions after age 72.
4. Safe Harbor 401(k)
Is a legal term that allows a company or person that meets certain requirements or regulations to skip the nondiscrimination rule.
The nondiscrimination rule states in order to be a qualified plan all employees, from the lowest paid to the highest paid receive the same investment packages, employer match, and tax breaks.
For an employer -sponsored retirement plan to be eligible for certain tax benefits, they need to meet the requirements of the IRS and ERISA. They also have to be maintained when transferred or amended.
Employers that offer safe harbor 401(k)s must contribute annually to all eligible employees, no matter how long the employees have worked for the company or whether or not the employees contribute. The contributions are also immediately vested.
How do 401(k) Plan Vesting Schedules Work
Any contributions you make to your retirement plan belong to you. The contributions made by your employer work differently.
Employer contributions may be dependent on a vesting schedule. A vesting schedule in a 401(k)-retirement plan may require an employee to have worked for the company a certain number of years in order to keep the employer’s portion of the contributions.
Depending on the employer, you may be subject to forfeiting some or all of the employers’ contributions. This can range from 0% - 100% depending on how long you have worked for the company. For example, if you are 0% vested it means you only get to keep your portion of the contributions. If you are 100% vested it means you get to keep yours and the employer’s contributions.
Another example would be if you are vested with your employer after 5 years and you quit prior to 5 years, you may have to pay some or all of what the employer contributed.
Safe harbor 401(k)s have the same rules as other employer 401(k) plans on withdrawing early, contributions, and required minimum distributions.
For those with multiple 401(k) plans, you cannot exceed the maximum contribution. This means if you have an employer 401(k) and you are self-employed and own a small business 401(k) you would not be allowed to exceed the $23000 per year ($30,500 if you’re over 50 for 2024) between the 2 of them.
5. One-Participant 401(k)
Also known as solo 401(k), or self-employed 401(k). These are designed for business owners and a spouse if the spouse also works in the business, and they do not have employees.
The advantage of these is that the owner can contribute as an employee and as an owner since they are considered both.
Each spouse can contribute 100% of their net income and as an employee, then they can make an additional nonelective contribution as an employer. The maximum contribution will depend on how they are set up. Are they set up like a sole proprietorship, or S-Corporation?
This can be as much as $69,000 per spouse to their 401(k) plan (for 2024), and if they are over 50 another $7,500 per spouse.
Basic match: The employer matches 100% of each non-highly compensated employee’s elective contributions, up to 3% of their compensation. Also, it matches 50% of the next 2% in compensation. So, for example, an employee who earns $50,000 a year would be eligible for a maximum match of $2,000 (100% of their first $1,500 in contributions plus 50% of the next $1,000).- Enhanced match: The employer can base its match on up to 6% of the employee’s compensation, rather than just 5%, as with a basic match.
- Nonelective contribution: The employer contributes an amount equal to 3% of compensation on behalf of each non-highly compensated employee. Employees are not required to contribute.