401 (k) Plan for Savings and Retirement

In this article let us understand the meaning of a 401 (k) plan, eligibility criteria, how the plan works, caveats to the rule and difference between a 401 (k) 403 (b) plans.

30th September 2013

Fidelity Investments, the top retirement plan providers in the U.S. has been sued by its own employees over the 401 (k) plan it offers to its own workers. Employees claim that the plan is dominated by expensive Fidelity mutual funds when lower-fee options are available within Fidelity’s own offerings and from other providers. Fidelity is the 401 (k) provider for 12 million workers across thousands of companies, the employees who have filed the suit claim that the investment options available in the Fidelity plan were offered by Fidelity or a company subsidiary. By the end of 2010, nearly 85 percent of the plan’s assets were held in actively managed Fidelity mutual funds, which tend to have higher fees than passively managed index funds. The complaint comes in the wake of a series of 401 (k) related law suits against financial firms and other companies that allege mismanagement of funds and high fees. The Federal Employee Retirement Income Security Act clearly says that companies with 401 (k) retirement plans have a “fiduciary responsibility” to act in the best interest of their employees. A spokesman from the company sought the dismissal of the lawsuit as it was without merit and baseless allegation from a group of employees from the company; he said that the company provides its employees a wide variety of investments to choose from, including low cost index funds.

In this article let us understand the meaning of a 401 (k) plan, eligibility criteria, how the plan works, caveats to the rule, difference between a 401 (k) 403 (b) plans and the law suit filed against Fidelity Investments for its alleged role in the misuse of 401 (k) plans of its own employees.

What is a 401 (k)?

A 401 (k) is a retirement plan sponsored by an employer; the workers can save a portion of their salary before deduction of taxes. It is the most common kind of defined contribution retirement plan, it is named for the section of the tax code that governs them, 401 (k)’s became popular in the 1980’s as a supplement to pensions. Most employers used to offer pension funds, these Pension funds were managed by the employer and they paid a steady income during the time of retirement, but as the cost of pensions escalated, employers decided to replace them with 401 (k)’s. The term 401 (k) is a reference to a specific provision in the U.S. Internal Revenue Code, however, its popularity has made other nations use it as a generic term to describe the analogous legislation.

For example: In 2001, Japan adopted the version by using 401 (k) accounts even though no provision of the Japanese code is called 401 (k). The term is not used in U.K. where analogous pension arrangements are known as personal pension schemes.

How does it work?

The employee can decide the extent of contribution made to the plan, since the plans offer valuable tax breaks, employee can make the maximum contribution to the fund. As on 2013, the maximum limits to the fund was $ 17,500 if he was under the age of 50. If the employee is more than 50, he can make an additional catch-up contribution of $5,500, for a total of up to $ 23,000. The investment happens through payroll deduction and the employee can decide what percentage of salary he can contribute, the amount shall be deducted and deposited into the fund. The company where the employee is working shall serve as the “plan sponsor”, the company does not invest the money, instead, it hires another company to administer the plan and its investments. The plan administrator may be a mutual fund company such as Fidelity, Vanguard or a brokerage firm such as Schwab or Merrill Lynch or even an insurance company such as Prudential or MetLife. The employer sends the payroll deductions directly to the company managing your plan, but the employee should decide the course of investment among the various options.

Caveats to the rule

The 401 (k) plan has lots of caveats and restrictions, the employer contribution cannot be withdrawn until a specific time limit, employers generally use this plan to control attrition rates and prevent early leaving by employees thereby strengthening their human resources. There are complex rules on the withdrawal limits and the company can impose heavy penalties for withdrawals before superannuation.

What if the company goes bankrupt?

If the company ceases to function, the plan would be terminated. If that happens, employees can roll the money into a traditional IRA to avoid paying the 10 percent withdrawal penalty and income taxes.

Difference between 401 (k) and 403 (b) Plan

Both 401 (K) and 403 (b) plans are employer sponsored retirement benefit plans that offer tax savings. Structurally both the plans are similar, the main difference lie in the eligibility of participants and the reporting requirements for employers.