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What Is a 401(k) Plan and How Does It Work?

You've dreamed about retirement for years now. A sandy beach, a perfect tan, a cocktail in your hand -- life will be great once you decide to retire. While this may or may not be your ideal fantasy, retirement is a future reality. How you plan for it now will affect your ability to maintain your current standard of living. 

One powerful tool for achieving your retirement dreams is a 401(k) plan. This employer-sponsored retirement account allows you to contribute a portion of your pre-tax salary, directing your investments and building a nest egg for your future. Understanding the workings of 401(k) plans and strategically managing your retirement accounts is crucial for securing a comfortable and fulfilling retirement lifestyle.

401(k): Your Ticket to Retirement

It's normal to wonder what is a 401(k) and how it works. Millions of Americans are building their retirement incomes via employer-sponsored plans such as 401(k)s.

A 401(k) is an employee benefit that's a key tool for securing retirement benefits. Most retirement savings plans are governed by federal law, with most falling under the Employee Retirement Income Security Act (ERISA). ERISA is administered by the U.S. Department of Labor (DOL). 

As an employee, you can participate in your company's 401(k) plan and contribute part of your pre-tax salary. In many instances, you direct your investments as well.

In this article, we will answer some common questions about the fees and expenses your 401(k) plan may require. These fees should be taken into account in your decision-making. Together we can sift through the information to help you make informed decisions about your investment.

Types of 401(k) Plans

Various types of 401(k) plans offer flexibility to cater to different needs. The eligibility criteria for these plans may vary. Plan sponsors determine who qualifies to participate.

One common structure includes employer contributions. This is when employers contribute a percentage of an employee's salary to their retirement account. Matching contributions serve as an additional incentive for retirement savings and are determined based on the employee's contributions during a 12-month period. 

Automatic enrollment is a feature in some plans that enrolls eligible employees by default unless they choose to opt out.

Some plans extend these benefits to part-time employees, ensuring broader participation. Plan participants can also make employee contributions, contributing a portion of their pre-tax salary to boost their retirement savings. 

A safe harbor 401(k) plan is designed to simplify compliance with certain regulations, offering benefits like automatic employer contributions to ensure accessibility for all employees. Understanding the nuances of these 401(k) plan types allows individuals to choose the option that best aligns with their financial goals and employment circumstances.

Other Types of Retirement Plans

Beyond 401(k) plans, several other retirement options cater to diverse needs. These include:

  • Individual Retirement Arrangements (IRAs) allow individuals to save for retirement with potential tax advantages. 
  • Profit-sharing plans are popular among business owners, allowing them to share profits with employees. 
  • Defined contribution plans, a category that includes 401(k)s, offer flexibility in contributions. 
  • Qualified retirement plans, including pension plans, are established by employers to provide financial security for employees during retirement. 
  • Employers may also offer health plans and benefits like COBRA to support retirees. 

Understanding the range of retirement plans available allows individuals and small business owners to choose options that align with their financial goals and offer comprehensive benefits for their employees.

Tax Advantages

401(k)s offer compelling tax advantages for both employers and employees. As fiduciaries responsible for managing retirement plans, employers can take advantage of tax benefits outlined by the Internal Revenue Code (IRC). 

Contributions made by employees to their 401(k) accounts are often tax-deferred, meaning they can reduce their taxable income in the current year. Employers may also receive tax benefits for contributing to employees' accounts. 

In addition, plan assets grow tax-free until withdrawal. Vesting, which refers to the ownership of employer-contributed funds, may also impact tax considerations. 

Understanding the tax advantages of 401(k)s is crucial for employers and employees alike, as it enables them to make informed decisions about retirement planning and navigate the intricacies of the IRS regulations governing these plans.

Your Retirement Plan Has Fees: Did You Know That?

You may not be aware that your retirement fund charges fees. Many Americans are unaware of this fact, but it is important to note that fees and expenses paid by your plan may reduce the growth in your account by a substantial amount.

Retirement Plan Fee Example

You've been working and contributing to your 401(k) for 30 years. You've managed to save $10,000 a year for each of those years. If you average 7% returns annually and pay 0.5% in annual expenses, you've saved $920,000. With 1% in annual fees, that total drops to a little less than $840,000. If the number is 2% in annual fees, your finishing total is just under $700,000.

Why is this important? Simply put, the cumulative effect of the fees and expenses on your retirement savings can be substantial.

What Are 401(k) Plan Fees and Who Pays for Them?

An investor pays an ever-increasing amount in fees as account balances grow because the fees are based on a percentage of assets and the particular investment the employee selects.

Fees diminish the portfolio's overall returns because every dollar taken out to cover management costs is one fewer dollar left to invest in the portfolio to compound and grow over time. So in addition to paying potentially hundreds of thousands of dollars in avoidable fees, you may also be losing that amount in portfolio returns over time.

401(k) plan fees and expenses generally fall into three categories:

  • Plan Administration Fees: These are the fees associated with the operational tasks, such as record keeping and legal services. The key is to understand if you or your employer is paying for these fees Many employers pay the fees associated with these operations, while others pass them on to you.
  • Investment Fees: There are many different fees tied to your investment. One type of fee is tied to expense ratios. Expense ratios are the annual fees linked to mutual funds, index funds, and exchange-traded funds. Try to pick funds with the lowest expense ratios.
  • Individual Service Fees: These are fees associated with optional features offered under a 401(k) plan. Individual service fees are charged separately to the accounts of individuals who choose to take advantage of a particular plan feature. For example, individual service fees may be charged to a participant for taking a loan from the plan to buy a house or pay other bills or for executing participant investment directions.

More Information About Fees and Expenses Associated With a 401(k)

If you have questions about the fees and expenses charged to your 401(k) plan, you have options for finding answers. First, start with your plan administrator for specific information. They can give you copies of your account statements showing the total assets in your account, how they are invested, and any increases or decreases in your investments during the period covered by the statements.

You can also consult the business section of major daily newspapers, business and financial publications, and rating services, most of which can be found online.

If you still have questions regarding the rates of return or fees of your plan's investment options, you may want to consult with a tax professional for a better understanding.

Other Factors Impacting Fees and Expenses

As you continue to educate yourself on retirement plan options, you'll encounter other types of fees you could be hit with.

If you have an investment adviser actively managing your investment, your costs will be higher. The higher fees are associated with the more active management provided and sales charges from the higher level of trading activity.

If your funds are passively managed, your fees will be lower. Passively managed funds work by seeking to obtain investment results of an established market index, such as Standard and Poor's 500, by duplicating the holdings included in the index.

Optional features, such as participant loan programs and insurance benefits offered under variable annuity contracts, involve additional costs. Consider whether they have value to you.

What Is a 401(k) Plan and How Does it Work: Additional Resources

Listed below are some links to help you continue your research. For the most accurate information, contact your plan's administrator, a financial planner, or a skilled employment law attorney.

Legal Questions About Your 401(k)? Speak With a Lawyer

Retirement planning is a proactive activity. If you wait too long, you may not have the income you need to sustain your standard of living. Having good, solid investment advice and planning from a skilled professional about your employee benefits can make all the difference. If you're seeking legal advice, consider speaking with a lawyer with a background in ERISA laws today.

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