3433-vol. 6 issue 2-3.pmd - iarfc

52
Journal of Personal Finance
401(k) Plans
In 1978, Section 401(k) of the Internal Revenue Code created a new
type of defined contribution plan funded primarily by employee contributions.
Employees have the option of making all or part of their contributions on a
pre-tax or post-tax income basis. The pre-tax contributions are most often in
the form of payroll deductions – so-called “elective deferrals.” Although not
required, employers often provide matching contributions to these plans up to
a pre-established percentage or amount. Many employers require that the
employee complete a probationary period before the employee is allowed to
participate in the plan or before the employer will match the employee
contributions.
One advantage which the 401(k) has over a traditional defined
benefit pension is that it is usually portable. If the employee changes jobs, the
contributions made into one company’s 401(k) may, in many cases, be moved
into the employee’s 401(k) plan with a subsequent company. However,
because a 401(k) is a company-administered plan, every plan may be somewhat
different. Consequently, the impact that changing jobs may have on the
employee’s 401(k) could be significantly different depending on the plan. But
the employee always has the option to roll the 401(k) balance from a former
employer into a self-directed IRA, thus giving the employee greater control
over the costs of plan administration and the investment choices available.
Participants in a 401(k) plan also generally have much more control
and choice over their investment options than with a traditional defined
benefit pension. Typically, the employee chooses how to invest the contributions
to the 401(k) plan and is allowed to change where current and future
contributions are invested. Although the number of investment choices in
plans varies widely, the average rose to 17 based on a 2005-2006 survey of 830
plan sponsors nationwide, up from the average 15 choices reported in 2004
(Deloitte Consulting LLP, n.d.). Prior to the passage of the Pension Protection
Act of 2006 (PPA), if no choice was made, the usual default was to a
money market option.
Under prior law, employers had to be aware of limitations placed
upon their defined contribution plans due to non-discrimination rules which
prohibited favoring highly compensated employees. The PPA of 2006
alleviated this problem by providing for the automatic enrollment of all
employees in defined contribution plans. As long as a company makes the
prescribed contributions, stated as a percentage of the employee’s compensation,
it is not subject to the non-discrimination rules that apply to employer
matching contributions and employee elective deferrals. Specifically, the
prescribed range of the automatic contribution must be between 6% and 10%
of the employee’s compensation. For the first year of adoption, the contributions
must be at least 3% of compensation with this minimum increasing 1%
per year until the automatic contribution minimum of 6% is reached.
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