The responsibility for keeping money rolling into households in retirement is shared between individual employees and their employers. A 401(k) fund can be the best choice for an employer plan while a self-directed 401(k) can maximize the control exercised by individuals.
The 401(k) employer plan differs from the traditional fixed monthly payment plan in that it has preset contribution levels. This means that employees are required to invest their salaries and to be actively involved in guiding and adjusting those investments. 401(k) funds are now the dominant employer plan in the public sector. They are classified, by the IRS, as ‘profit-sharing’. However they do not necessarily involve true profit sharing.
Other types of retirement provision are available to employers such as the 403(b) for employees in educational and not for profit organizations, or Employee Stock Ownership Plans and profit-sharing ones.
401(k) funds offer tax deductions and flexibility in both the way the plan is set up and in the investments that individuals decide to make. 401(k) self-directed funds differ from the traditional a pension plan in that workers keep the benefits when they change employer. They are also insured against the bankruptcy of the contributing employer.
The choice of 401(k) fund structure is the first and most fundamental decision to be made when an employer establishes a fund. There are three distinct types of 401(k) plans:
- A ‘Simple’ 401(k) fund is the best option for small to medium sized companies with fewer employees who received a minimum of $5,000 in pay in the previous year. Employees can only draw contributions or benefits accruals from this plan from the one employer. These kinds of 401(k) fund are not subject to nondiscrimination reviews that aim to ensure fairness of benefits between workers, owners and managers.
- ‘Traditional’ 401(k) funds is where employers can make matching contributions to employees’ deferrals. Companies can apply a ‘vesting schedule’ that sets minimum service periods before a getting the matched contributions. Employees who join the fund make deductions direct from their salary. Each year reviews are done to ensure that workers get proportional benefits in line with owners and managers.
- A ‘Safe Harbor’ 401(k) fund is like a traditional plan, but the tax rules are much simpler and the employer contributions have to be fully vested from the start. Not subject to annual nondiscrimination testing
The justification for establishing and joining employer/employee retirement funds is a lot about the time when tax is paid. In most 401(k) funds, employees put a proportion of their salary in to the plan before income taxes are deducted. The capital growth and interest on the funds is also not subject to tax deductions. Only when the retirees make withdrawals are they subject to tax.