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401(k) plans are qualified defined contribution retirement plans. They are qualified because they meet the tax law requirements for favorable tax treatment and defined contribution in that the benefit at retirement will not be defined until all contributions are made. At retirement age, the individual will receive an income based upon the amount of money accumulated. Defined contribution plans, such as profit sharing plans, permit a maximum of $30,000 to be contributed in an employee’s name. However, the special option under which the 401(k) plans are instituted, limits an individual’s contribution to $10,500 in 2001. Normally these plans have three accounts:

Tax Code Section 401(k) allows employees to set aside pre-tax income in a qualified savings plan and to accumulate interest on a tax deferred basis until withdrawal. The 401(k) plan is an option added to a qualified profit sharing plan, but it is more often referred to as a salary reduction plan. It allows employees to elect how much of their salary/bonus on a pre-tax basis is to be deposited to the plan. For tax purposes, this money is treated as a form of company contribution to a thrift plan. This tax treatment allows the employee’s taxable income to be reduced, therefore decreasing federal income and state income taxes. It does not, however, reduce FICA or Social Security.

Another unique benefit of the 401(k) plan is the contribution flexibility. Within certain limits, participants may choose how much income they will defer without regard to how much other participants contribute. This flexibility makes it possible for individuals with diverse savings objectives to attain their respective financial goals without interfering with the desires of colleagues. 401(k) plan advantages are:

This must not exceed the annual limit. This dollar amount will increase with inflation. The 401(k) maximum far exceeds the IRA limit of $2,000 that may not be deductible if either the individual or spouse is covered in an employer-sponsored plan.

These are not substantial, but when securities are purchased for the employee’s account, there is normally a substantial reduction in the standard expense charges.

This is true since 401(k) contributions can be withheld on a payroll deduction basis. In addition, employees will likely save more since they contribute with each paycheck.

Withdrawals from a 401(k) plan due to separation of service or because of "financial hardship" are not subject to the ten-percent penalty tax. Financial hardship means an unanticipated financial disaster. This certainly includes severe medical expenses. However, there is some doubt as to whether or not this would include the education of a child or purchase of a home.

Loans up to $50,000 if less than one half of the account may be made, subject to systematic repayment within five years except for loans made for a principal residence. Interest on loans is not deductible, except for loans secured by residence.

Money accumulated in a 401(k) plan may be eligible for a ten year carry-forward provision permitting the tax burden to be favorably calculated provided the participant was age 50 on or before January 1, 1986, (Born before December 31, 1936).

BASIC PRINCIPLES

There is several guidelines, or restrictions, set forth by the IRS for 401(k) plans. The first restriction is the overall and individual contribution limits mentioned above. In order to ensure that a 401(k) plan is not established or operating in a discriminatory manner, the IRS has published non-discrimination tests. Companies offering 401(k) plans must pass these tests. The tests relate to:

The 401(k) plan offers one of the best "tax shelters" available today with flexible options for both the employer and the employees.

Securities offered through Sigma Financial Corporation. A registered broker/dealer. Member FINRA & SIPC.

Planning Services offered through Sigma Planning Corporation, a registered investment advisor.

Any information contained on this site does not constitute financial advice. The Website is intended to provide general information only and does not attempt to give you advice that relates to your specific circumstances. You are advised to discuss your specific requirements with an independent financial adviser licensed in your state.

We do not offer legal advice. All information provided on this website is for informational purposes only and is not a substitute for proper legal advice. If you have legal questions, we recommend that you seek the advice of legal professionals.

IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.

Asset allocation, diversification and rebalancing do not assure a profit or protect against loss in declining markets. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Past performance is no guarantee of future results.

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Last modified: 05/11/10