What is a 401(k)?

A 401(k) is a type of retirement plan that allows employees to save and invest for their own retirement. Through a 401(k), you can authorize your employer to deduct a certain amount of money from your paycheck before taxes are calculated, and to invest it in the 401(k) plan. Your money is invested in investment options that you choose from the ones offered through your company's plan. The federal government established the 401(k) in 1981 with special tax advantages, to encourage people to prepare for retirement. They get their catchy name from the section of the Internal Revenue Code which established them (you guessed it, section 401(k)).

How does a 401(k) plan work?

You decide how much money you want deducted from your paycheck and invested during each pay period, up to the legal maximum (the IRS sets an annual dollar limit each year). You also decide how to invest that money, choosing from your plan's different investment options. The money you contribute to your 401(k) account is deducted from your pay before income taxes are taken out. This means that by contributing to a 401(k), you can actually lower the amount you pay each pay period in current taxes. For example, if you earn $1,000 each paycheck, and you contribute, say 5% ($50), you are only taxed on $950. You don't owe income taxes on the money until you withdraw it from the plan, when you could be in a lower tax bracket.

What's the difference between saving money in my company's retirement plan and putting money into a mutual fund or bank account?

Taxes, taxes, taxes! An ordinary savings account or mutual fund doesn't allow you to save on a tax-deferred basis. So in an ordinary savings account, you're saving money that has already been taxed, and you continue to pay tax annually on the earnings of that account, too. The money you contribute to your company's 401(k) retirement plan, however, comes out of your paycheck before taxes are taken out. Plus, you don't pay income tax on the money you contribute to your 401(k) account or on any earnings until you take it out, which is usually at retirement, when you may be in a lower tax bracket. The bottom line: More of your money is working for you instead of going toward taxes. Keep in mind, however, that investing in your company's retirement plan is only a part of a sound retirement saving plan. It is still important to have personal savings aside from your retirement savings, too.

What's the difference between a 401(k) plan and my company's profit sharing plan?

A "profit sharing plan" is a type of retirement plan. It allows an employer to share profits of the company with employees by contributing a percentage of the company's annual profits to the plan. The amount of the contribution can change each year, or may not be made at all, depending on the company's circumstances.

A 401(k) plan is a feature of a profit sharing plan or a stock bonus plan. Unlike a profit sharing plan, however, employees can contribute a percentage of their own salaries (up to certain limits) to the plan for retirement savings. 401(k)s also allow employers to contribute money to its employees' accounts in the form of "company match" contributions, usually as an incentive to get employees to participate in the plan. Current income taxes are deferred on both employer and employee contributions and all investment earnings, until the money is withdrawn from the plan.

The maximum pre-tax amount that you can contribute to a 401(k) in 2005 is $14,000. In 2006, the maximum contribution amount increases to $15,000 as provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. After 2006, these contribution limits will be increased in $500 increments to factor in the effects of inflation. It's important to remember that your company's plan may have additional limits.

What if my company goes bankrupt? How is my 401(k) money protected?

The Employee Retirement Income Security Act (ERISA) of 1974 established guidelines for how money in 401(k) plans is maintained. The upshot of it is that your 401(k) plan account is not considered an asset of your employer-it is held in trust in a separate account for you. This means that your plan money (which includes all your own contributions and all vested company contributions) is not commingled with your company's money. And, your company cannot access your plan money for any purpose related to maintaining its business.

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Profit Sharing & Money Purchase

Qualified Retirement Plans like Profit Sharing and Money Purchase Plans are types of retirement plans that are funded by the employer. They allow employers to contribute to an employee's account, while offering them business tax deductions and tax-deferred savings.

How the Profit Sharing Plan works
Profit Sharing Plans are designed for companies with fluctuating or uncertain profits. These plans can be established by sole proprietors, partnerships, or corporations. Companies can make a discretionary contribution of up to 15% of an eligible employee's total compensation. In a Profit Sharing Plan, the employer has the flexibility to determine the contribution amount each year. Contributions do not have to be dependent on profits. Contributions by the employer are tax deductible as a business expense and are not treated as taxable income to the employee.

How the Money Purchase Plan works
In Money Purchase Plans, the employer's contribution is mandatory. The contributions are usually based on each employee's compensation. The employer sets specific eligibility and vesting requirements, and contributions can be as high as 25% of total compensation or $30,000 whichever is lower. Money Purchase Plans are less flexible than Profit Sharing Plans because contributions must be made even if the company has no profits.

Profit Sharing & Money Purchase Combination
Many companies choose to implement both of these types of plans in conjunction with one another. This allows for a greater total contribution percentage. By combining these two types of plans, an employer can effectively contribute 25%, up to $30,000. A typical example of how this works is an employer making a 10% mandatory Money Purchase contribution, and a discretionary 15% contribution into the Profit Sharing Plan. This type of approach offers some flexibility while maximizing the potential contribution percentage.

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SIMPLE IRA Plan

The Savings Incentive Match Plan for Employees-IRA replaced the SARSEP-IRA for plans established after January 1, 1997. A SIMPLE-IRA is specifically designed for companies with less than 100 employees. Companies with more than 100 employees cannot use the SIMPLE Plan. Additionally, companies cannot maintain or contribute into any other type of retirement plan. In a SIMPLE Plan, contributions are made by both employer and employee. Contributions are made on a pre-tax basis, thus giving added tax benefits to the plan's participants.

How a SIMPLE Plan works
Employees can contribute 100% of their earned income up to a maximum of $6,000 per year into a SIMPLE Plan. There is a mandatory employer match. This can be either a 100% match on the first 3% of employees' total compensation for all eligible employees who elect to participate in the plan, or a 2% match on total employee compensation regardless of employee participation. A SIMPLE plan can work great for a family-run business. A husband and wife business can put in up to $24,000 combined depending on their compensation. A SIMPLE Plan offers you and your employees the opportunity to contribute money on a pre-tax basis into a retirement account. SIMPLE Plans are easy to set up and maintain, and have minimal maintenance costs.

The HCI Advantage
A strong benefits package helps you recruit and retain valuable employees. We help our clients tailor a program that will fulfill both the employers' and employees' needs. Please call HCI at 713-626-2838 or use our Contact Form.

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