If you currently work or have worked for, a public company there is a good chance you have some experience with a 401(k) plan. They are one of the most popular types of workplace retirement plans offered among mid and large size employers. Despite their wide availability, there are a vast array of rules governing 401(k) plans which can make them confusing for employees and even employers. Let’s dive in a little deeper and try to navigate some of the most common rules.
Why do 401(k) plans have so many rules?
Due to the protections provided to 401(k) accounts through ERISA (The Employee Retirement Income Security Act of 1974) a strict set of rules and tests apply to these plans. The purpose of ERISA is to provide a set minimum standard for retirement plans to protect the individuals participating.
We can break down these rules in to two main types; information disclosure and fiduciary responsibility rules.
First, employers are required to disclose certain information to employees so they can make educated decisions whether they want to participate and the options available to them. Here are a few disclosures and their descriptions:
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Summary Plan Description (SPD) – A shortened version of the Plan Document which includes information such as matching contributions, Roth designated account options, vesting schedules, eligibility criteria, etc. It is designed to operate in a language easier to understand than the full Plan Document (although admittedly, still not that easy).
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Annual fee disclosure notice – This notice demonstrates the direct plan level and individual level fees that could be deducted from a participant’s account.
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Quarterly Statements – This should show a participants total account and vested balance for the last day of the quarter as well as any direct fees deducted in the quarter. The investment performance of the account is also typically listed, but not required.
Second, are fiduciary responsibilities the employer must uphold. The most well-known obligations focus on protecting the employees including:
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Ensuring the fees associated with the plan are reasonable.
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Providing a diversified investment line-up (which legally only means three options with different risk / return factors) and exercising “the judgment that a prudent investor would use in investing for his or her own retirement”.
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Avoiding conflicts of interest
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Making sure the plan is non-discriminatory.
Overall, the Plan Sponsor should be creating an employee benefit designed to recruit, retain and help improve everyone’s retirement readiness. Since the company employees tasked with selecting and monitoring the retirement plan have many other responsibilities, it is hard for them to be experts in this complex area. This leads to high variability in the quality of 401(k) plans from company to company. In addition, many of the features of 401(k) plans are optional and can change from plan to plan. We hope you will take some time to review many of the common provisions highlighted below so you can better navigate your own plan’s options.
Who is eligible to participate in a 401(k)?
Before you can participate in a 401(k) plan there are certain criteria you must satisfy as outlined in the Summary Plan Description. The most common being you must be 21 years of age and have worked at least 1,000 hours in a year. Companies can be more generous and allow eligibility at age 18 and immediately upon being hired, but most tend to wait due to short-term employee turnover. The next aspect after Eligibility is Entry Dates. It is a common practice to have specific enrollment dates for all new eligible employees entering together either monthly, quarterly or semi-annually. This means after an employee meets the eligibility criteria, they are free to sign up during these enrollment windows.
Despite the protections, there are still classes of employees who can be left off this list. Those include part-time employees, interns, nonresident foreign employees, anyone covered by a union contract, and 1099 independent contractors. A silver lining for many independent contractors is that they often operate under an entity they formed, which could set up its own retirement plan.
What does it mean if my plan offers Auto Enrollment or Auto Escalation?
When you become eligible to participate in your company’s 401(k) plan it often requires you to opt-in to making contributions. This will entail some form of registration where you select how much you choose to save and how you want the money invested. However, if your plan has auto enrollment, you will automatically be enrolled at a predetermined rate and into a default investment option (called a QDIA or Qualified Default Investment Alternative). For example, when you become eligible you will be automatically signed up to contribute 3% of your salary into a Moderate Allocation Fund. You will always have the option to opt out or change your contribution rate, but you must actively do so.
Auto escalation will increase your annual contribution rate, usually by 1% each year until you hit a threshold such as 10%. When many employees first start a new job, they may not be adjusted to the new income and prefer to start with a lower contribution rate. Unfortunately, a very high percentage never go back and adjust the amount they are saving down the road, leaving them behind on their progress. This feature is meant to help that result and similar to auto enrollment you can always opt out of it.
What does it mean if my company matches my contribution?
When you decide to contribute to your 401(k) account, your employer can choose to make a contribution to your account. This is meant to incentivize you to save for your own retirement and is a valuable retirement planning booster. The “matching” contributions follow a formula spelled out in the plan documents and highlighted in the Summary Plan Description. The two most common matching formulas are matching 50% or 100% of your contribution, or a combination of the two, up to some percentage of your gross compensation. Here are a few examples for someone earning $100,000 of compensation:
|
Matching Formula |
Your Contribution |
Company Match |
|
100% matching up to 3% of compensation |
$2,000 |
$2,000 |
|
100% matching up to 3% of compensation |
$4,000 |
$3,000 |
|
50% matching up to 6% of compensation |
$4,000 |
$2,000 |
|
50% matching up to 6% of compensation |
$8,000 |
$3,000 |
|
100% matching up to 3% of compensation, then 50% for the next 2% of compensation |
$4,000 |
$3,500 |
|
100% matching up to 3% of compensation, then 50% for the next 2% of compensation |
$8,000 |
$4,000 |
If your 401(k) plan has what is called a Safe Harbor provision, that means that the company has elected to use one of the approved employer contribution formulas set out by the IRS. These are the Basic match, which is a 100% match on the first 3% of deferred compensation plus a 50% match on deferrals between 3% and 5% (4% total), and the Enhanced match, which must be at least as much as the basic match at each tier of the match formula. This is commonly done using a 100% match on the first 4% of deferred compensation by the employee. A few plans even use the Safe Harbor nonelective contribution, which isn’t a matching formula at all, but rather an employer will contribute 3% or more of your compensation into your retirement account without any contribution from employees.
If your company is following a safe harbor matching formula the money the company contributes is immediately vested, so you could leave at any time and take it with you. If the company is doing a non-safe harbor matching program, they may apply a vesting schedule, which requires you to be working at the company for a period before the company’s contributions become yours. Often it may be three years, or a phased vesting scheduled where you get a larger percentage of the funds each year over a longer period such as six years (0%, 20%, 40%, 60%, 80%, 100%). Before you change jobs look to see if there are any employer contributions you may be leaving behind. Also, make sure you understand how many hours are equivalent to working a vested year (i.e. 1000 hours or still employed at the end of the year).
What is the difference between a 401(k) and Roth 401(k)?
The main difference between these two is the way they are taxed. You have to pay taxes, but the question is would you rather pay them now or later. A traditional 401(k) account allows you to contribute before income tax is calculated, which is why it is also referred to as a pre-tax account. This means when you take money out of the account in retirement, or earlier via a hardship distribution, you pay ordinary income tax on the entire amount distributed. [Note: If you are under age 59 ½, there may be an additional 10% penalty tax on the funds.] A Roth 401(k) account contribution is made AFTER income taxes are withheld. So when you take money out of a Roth account in retirement both the contributions and the earnings are generally distributed tax free. Also, keep in mind Roth 401(k) contributions are not limited by an individual’s income and the contribution amounts follow 401(k) limits which are both different from Roth IRA rules.
If you are unsure which is better, you can always contribute to both at the same time as long as your combined contribution stays under the annual limits (2019 limit is $19,000, plus an additional $6,000 if you are over age 50).
What is a hardship distribution from a 401(k)?
A hardship withdraw is a distribution from your 401(k) account specifically used to cover an immediate and heavy financial need. It is meant as a last resort for spending which comes with rules, restrictions and penalties. It is generally a terrible way to access your money, but we’ll cover the basics anyway.
You must qualify for a hardship distribution, which can be harder than you may think. If you are under 59 ½ (55 in some plans) there isn’t an easy way to just withdraw your money without leaving your job first. The only exception is if you can qualify for a hardship distribution or a loan (which we’ll cover next) from the plan. While each plan can have slightly different rules, here are the most common immediate and heavy financial needs that may qualify you for a hardship distribution.
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Expenses for medical care (under §213(d) of the Internal Revenue Code) that are incurred by you, your spouse, your dependent, or your plan’s primary beneficiary
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Costs directly related to the purchase of your principal residence
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Tuition, related educational fees, room and board expenses for the next twelve months of post-secondary education for yourself, your spouse, your dependent, or your plan’s primary beneficiary
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Amounts necessary to prevent eviction from your principal residence or foreclosure on the mortgage of your principal residence
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Funeral expenses for the participant’s deceased parent, spouse, child or dependent
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Expenses for the repair of damage to the participant’s principal residence that would qualify for the casualty deduction for income tax purposes
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Disaster-related casualty losses
If you have one of these expenses your next step would be to complete a request for the distribution and generally provide documentation supporting the amount you are requesting. For example, if you were withdrawing for a large medical expense the most you can ask for is the amount listed on the medical bill, plus any tax withholdings you will pay on the withdraw. Be aware, depending on the expense, quotes or estimates probably won’t qualify since the distribution is meant to cover an expense already occurred, not a potential future one.
When we mentioned that this is a terrible way to access your money, here are some reasons why. First, it can be hard to qualify and take more time to get approval than you have if it is a true emergency. Second, most hardship distributions come from pre-tax contributions, meaning you need to take out significantly more so you can pay the taxes now due and still cover your expense. Third, you are limited to the lessor of your immediate expense, plus taxes, or funds designated by the plan as hardship eligible. This will always include your contributions, but may not include your earnings, safe harbor matching contributions and other sources of money. The IRS issued proposed regulations to take effect in January 2019 including more sources of money as eligible for distribution, but they must be included in the plan document first before they are allowed. Finally, on top of the rules, restrictions, and taxes there is a 10% early withdraw penalty for those under 59 ½ unless your request falls under one of the very few exceptions, like medical expenses exceeding 10% of your adjusted gross income.
Should I take a loan from my 401(k)?
A loan is certainly better than a hardship distribution, but it comes with its own set of challenges. In a 401(k) loan you are borrowing from your vested account balance with a promise to repay it via a set schedule. Since there is an extremely wide spectrum in how loans are administered from plan to plan, we will discuss the most common variations, but be sure to check your Summary Plan Description for specific details.
I know it’s called a loan, but technically it is advancing your own retirement funds for a short period of time that you have to repay with interest. The interest rate charged is set by the Plan but must be representative of current interest rates. The twist is the interest is paid back to yourself over a period not to exceed five years. The one exception, if chosen, a plan can allow a loan to be repaid over a longer period for a principal home purchase.
Taking a loan from your 401(k) has more flexibility than with a hardship withdraw. The majority of 401(k) plans allow you to take a loan for any reason. Employers can put “hardship like” requirements on it, but very few do. Your plan may even allow you to take out more than one loan at a time, provided that the maximum amount does not exceed the lesser of $50,000 or 50% of your vested balance (if 50% of your vested balance is less than $10,000 you can still take out $10,000).
The reason loans are preferred is, unlike hardship distributions, the money is not taxed as income and there is no additional 10% penalty. This allows you to take out a smaller amount to cover a need. Overall you can get access to your money with no taxes, penalties, and regardless of your credit score. What’s not to like? Ah, the devil is in the details.
The first challenge is that the money you are borrowing is no longer invested in the market. This is especially damaging for anyone who uses the full five years to repay it. The second, is that you MUST make your loan repayments on a set schedule. If you miss one, then your loan would be deemed a distribution and all the horrible taxes and penalties would apply. Third, and potentially the most uncontrollable risk, is that you would lose your job during the repayment period. The right to borrow from your retirement account tax free and repay it only applies while you are employed at the same company you took the loan out from. If you leave for any reason (quit or fired) the loan becomes due. You can’t roll a loan over to an IRA or to another company’s retirement plan. You also lose the flexibility of repaying it over time. Thanks to a recent change to the rule you have a larger cushion than ever before, but you are still required to repay the loan in full by that year’s federal tax filing due date (if you leave work in 2019 it would be due when you file your taxes for the year in 2020). If you can’t repay the loan in time it becomes a taxable distribution just like a hardship withdraw, including all the penalties and taxes.
Can I move my old 401(k) to my new one?
Yes, you can, but that doesn’t always mean you should. Those decisions will depend on how good / bad your old 401(k) was, how good / bad your new 401(k) is, and a few other questions around keeping your options open.
Moving your old 401(k) plan into your new one makes it easier to monitor your finances and progress towards saving for retirement. Remember when you leave your job you can’t contribute to the old account anymore and it tends to be out of sight, out of mind. Moving your funds to your new 401(k) also opens the possibility of accessing your old funds via a loan (if you have to) from your new plan. Another point for moving over is when your new plan is just plain better as measured by lower expenses and more diverse investment options.
You might want to leave you money in an old 401(k) if that plan has lower fees, better investment options, or a unique feature like a high yielding fixed account (this means no risk of loss and a new annual rate declared each year). If you don’t plan on being at your new employer very long wait to transfer the money because you are assessed a one-time fee (typically $50 – $150) when doing so and those can add up if you switch every year or two.
The alternate solution is rolling your 401(k) into an IRA. On the positive side IRA’s typically give you the most flexibility in finding low cost, diversified options to invest in. On the negative side you can’t take a loan from your IRA and you could lose some of the creditor protections 401(k) plans enjoy because of ERISA law. The simplified version is if you file for bankruptcy the protection is the same, however with general creditors, rollover IRA protection is determined on a state by state basis.
What do I do with my 401(k) when I retire?
The purpose of saving in your 401(k) all those years was to use it in retirement to try and maintain a comfortable lifestyle. Once you retire, what you do with it depends on when you plan on spending it.
A few people find themselves in the enviable position of not needing the money right away. They may have passive income from another source, a spouse still working, or one of the lucky few with a great pension. Either way, if they really like their current 401(k) they could choose to do nothing with it until it is time to take their Required Minimum Distributions. Required Minimum Distributions, or RMDs, are IRS mandated withdraws you have to make from your pre-tax retirement accounts when you reach 701/2 years old (follow the RMD link for the specific rules).
If you need the money now, or have reached your RMD age, we feel you should look to roll over your funds into an IRA. If you don’t each withdraw you take from your 401(k) will result in a one-time processing fee, probably in the realm of $100. That really starts to add up. In addition, some plans will not allow monthly distributions so you might be forced into a one-time annual withdraw.
There are always exceptions, like if you hold a large amount of company stock in your 401(k) or if a higher level of creditor protection is necessary, but when you need the money dominates the decision most of the time. Regardless which option you choose make sure your beneficiary designations stay up to date. This designation overrides what is in your will and can cause huge headaches, and tax issues, for your family if not handled properly.
Know your plan
Since some plans will be more flexible, cost effective, and easy to navigate, make sure you read up on your 401(k) plan whenever you change jobs. You want to know all your options ahead of time so you can make the best decisions as you save toward your retirement.
If you would like to schedule a time to talk about your 401(k), or anything else in your financial life, please schedule a time HERE.