In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code.
The net benefit of the traditional account is the sum of (1) the same benefit as from the Roth account from the permanently tax-free profits on after-tax saving, (2) a possible bonus (or penalty) from withdrawals at tax rates lower (or higher) than at contribution, and (3) the impact on qualification for other income-tested programs from contributions and withdrawals reducing and adding to taxable income.
[4] Before 1974, some U.S. employers had been giving their staff the option of receiving cash in lieu of an employer-paid contribution to their tax-qualified retirement plan accounts.
[10] There are two main types corresponding to the same distinction in an Individual Retirement Account (IRA); variously referred to as traditional vs. Roth,[11] or tax-deferred vs. tax exempt, or EET[12] vs.
Effective tax rates are used to incorporate the impact of contributions and draws on the saver's qualification for benefits from other income-tested programs.
If the employee made after-tax contributions to the 401(k) account, these amounts are commingled with the pre-tax funds and simply add to the 401(k) basis.
The Internal Revenue Code imposes severe restrictions on withdrawals of tax-deferred or Roth contributions while a person remains in service with the company and is under the age of 59+1⁄2.
Any withdrawal that is permitted before the age of 59+1⁄2 is subject to an excise tax equal to ten percent of the amount distributed (on top of the ordinary income tax that has to be paid), including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).
As a response to the COVID-19 pandemic, the CARES Act allowed people to withdraw funds before the age of 59+1⁄2 up to $100,000 without the 10% penalty due[19][20] for 2020.
[21] The loan principal is not taxable income nor subject to the 10% penalty as long as it is paid back in accordance with section 72(p) of the Internal Revenue Code.
[22] This section requires, among other things, that the loan is for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan.
When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default".
When a former employee's account is closed, the former employee can either roll over the funds to an individual retirement account, roll over the funds to another 401(k) plan, or receive a cash distribution, less required income taxes and possibly a penalty for a cash withdrawal before the age of 59+1⁄2.
If the 60-day limit is not met, the rollover will be disallowed and the distribution will be taxed as ordinary income and the 10% penalty will apply, if applicable.
In order to do so, an employee's company plan must offer both a Traditional and Roth option and explicitly permit such a conversion.
[35] (Age 60–63) There is a maximum limit on the total yearly employee pre-tax or Roth salary deferral into the plan.
A failed ACP test is likewise addressed through return of excess, or a QNEC or qualified match (QMAC).
Prior to the Pension Protection Act, employers were held responsible for investment losses as a result of such automatic enrollments.
[52] The IRS monitors defined contribution plans such as 401(k)s to determine if they are top-heavy, or weighted too heavily in providing benefits to key employees.
[53] The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made 401(k) plans more beneficial to the self-employed.
Prior to EGTRRA, the maximum tax-deductible contribution to a 401(k) plan was 15% of eligible pay (reduced by the amount of salary deferrals).
For example, in October 2001, Japan adopted legislation allowing the creation of "Japan-version 401(k)" accounts even though no provision of the relevant Japanese codes is in fact called "section 401(k)".
In Canada RRSPs (Registered Retirement Savings Plan) play a similar role although they don't have to be employer sponsored and have different contribution limits.
Similarly, India has a scheme called National Pension System (NPS), mandatory for all Central Government employees from January 2004, which is similar to 401(k) in terms of investment options, restriction on withdrawals and tax exemption on contribution, return earned and also withdrawals at retirement age(generally 60).
It's regulated by PFRDA Pension Fund Regulatory and Development Authority Some old pension schemes like EPF for private or public sector employees and PPF for self-employed, practicing professionals, small business owners, exist but they offer a lower rate of return that is fixed by Government every quarter.The Employees' Provident Fund Organisation (EPFO) is a statutory body of the Government of India under the Ministry of Labour and Employment.
It is one of the largest social security organisations in India in terms of the number of covered beneficiaries and the volume of financial transactions undertaken.
Further diversification into bonds can protect against stock market declines, but generally have smaller earning potential and still carry the risk of bondholder default.
Conversely, 401(k) plans are sometimes criticized for putting the burden of choosing and updating investments on earners, most of whom are not experts in finance.
[58] This exacerbates existing income inequality, especially if these larger retirement savings are used for the benefit of children (for example to pay for a better education, or simply as inheritance).
Reliance on these plans instead of defined-benefit pensions and the small fraction of earnings replaced by government programs like Social Security means many people have an insufficient amount of money for retirement.