May 9, 2000
This Week, Ted Tackles:
What's the difference between 401(a) and 401(k) plans? … Is it typical for an employer to limit employee 401(k) contributions? … My 401(k) statement doesn't show share values—how can I calculate them? … Does the employer withhold the 10% early withdrawal penalty? … Are FICA and Medicare calculated before or after my 401(k) contribution? … The consequences of not rolling your 401(k) money over when you change jobs. … A reader replies: a 401(k)-contribution strategy for tip earners.
Question: What's the difference between a 401(a) and a 401(k), and who is eligible for them?
TB: The name 401(a) is used generally for a defined-contribution plan that's funded solely by employer contributions. These plans have been around for a long time and any employer can adopt this type of plan.
For-profit and nonprofit businesses may also adopt 401(k) plans (allowing employee contributions) in addition to a 401(a) plan. Section 457 plans are the alternative to 401(k)s for state and local governmental employees.
Question: The company I work for wants to limit the percentage that employees can contribute to the 401(k) plan. Is this typical? Do many companies limit their employees? If yes, why? Where can I get more information on this topic?
TB: All employers limit the amount their employees may contribute because the law contains various limits, which must be enforced. The most familiar 401(k) limit is the $10,500 annual maximum that an employee may contribute. There is also a 25% of pay limit, not to exceed $30,000, which applies to the combined employee/employer contributions for each employee.
Contributions for employees who are "highly compensated" must also be restricted so the plan will pass special non-discrimination tests that apply to all 401(k) plans. These tests tie the amount that highly compensated employees can contribute to the amount that the other eligible employees may contribute. Employees who earned more than $80,000 during 1999 are highly compensated employees. Typically, these employees are able to contribute somewhere between 4% and 8% of pay.
Employers commonly establish percent-of-pay contribution limits that are below the maximum permissible level. Many plans used 12% to 15% limits when they established their plans years ago. In 1999, a new law took effect permitting this percentage to be increased. Many employers, however, haven't amended their plans to do so. For example, if the maximum-employer contribution for your plan is 5% of pay, your employer should amend its plan to permit employees to contribute 20%, subject to the $10,500 limit.
Question: My home computer budget software has an update feature I want to use to keep track of my 401(k). I get a quarterly statement, but the software wants me to enter the price and number of shares, which my statement doesn't list. How can I calculate these?
TB: First, it isn't clear from the information you provided what you're using the program to do. I'll assume you're using the software to help you monitor your spending and to determine whether you're saving enough to meet your long-term retirement goals. One reason why many workers fail to save enough for retirement is because they fail to plan. Using this type of software can help you avoid this problem.
The fact that your statement doesn't give you shares and a share price makes it more difficult, but not impossible. What you need to do to solve this problem is convert your account into units or shares. Start with your last statement by dividing the ending value of your account by $10.00. For example, if your account has a $9,053.21 balance, you will have 905.321 shares. Feed this information into the program by using $10.00 as the share price and 905.321 as the number of shares.
Update your number of shares and the share value each time you get a statement. Increase the number of shares each time you get your quarterly statement by dividing the amount contributed during the quarter by the last share value. Assume the total contributions during the next quarter are $1,255.34. Divide this amount by the last share price, which will be $10.00 the first time you update. This will give you 125.534 additional shares for a total of 1030.855 (905.321 plus 125.534). Next, assume the total value of your account is $10,457.80 at the end of this quarter. Divide this amount by the number of shares (1030.855). This will give you a new share price of $10.15. Feed the new share price and number of shares into the program.
Follow the same process when you get your next quarterly statement using $10.15 as the last share price to get the number of new shares accrued during the quarter. Follow the same process if you withdraw money during any quarter to reduce the number of shares.
Question: I have a question concerning your April 18th column. The participant was concerned that the company withheld 30% from the distribution. It has always been my understanding that the employer is required to withhold only 20% from the distribution, and that the 10% early withdrawal penalty, and any additional income tax due, is paid when the participant files his or her income tax. On what basis is the company allowed to withhold 30% from the distribution?
TB: You're correct that the required withholding is 20% of the taxable distribution, excluding employer stock and participant loans. Apparently, whoever manages this plan thinks they should withhold the 20% mandatory amount plus the 10% penalty tax. As you're probably aware, the required 20% withholding has created a lot of misunderstanding.
Question: I understand that federal and state taxes are deferred on my 401(k) contributions—how about FICA and Medicare? Should FICA and Medicare be calculated based on my salary PRIOR to my 401(k) contributions, or my salary AFTER my 401(k) calculations?
TB: Your 401(k) contributions are subject to FICA and Medicare taxes. This wasn't the case in the early days of 401(k), but the law was changed during the early 1980s to make these contributions subject to these taxes.
Employee pre-tax contributions to a Section 125 plan aren't subject to these taxes. This is another example where our tax laws don't make sense due to inconsistencies. The emergence of 401(k) plans occurred at a point when our government was forced to act to prevent Social Security and Medicare from failing. So they changed the law to avoid losing Social Security and Medicare taxes on these contributions. Section 125 plans emerged after this legislation was passed. So far, contributions to these plans remain exempt from these taxes.
Question: I'm the CFO of a nonprofit organization and I am amazed at the number of terminating participants to our 401(k) plan who choose to have their plan assets distributed to them upon termination, as opposed to rolling them over into another qualified plan or IRA. Do you have any statistics on what percentage do actually rollover their funds into another qualified plan or IRA versus taking a distribution and suffering the penalty tax? I'm just wondering if we need to do a better job of educating participants as to why this is such a bad idea.
TB: The answer to your question is, yes, we need to do a better job educating employees about the pitfalls of using this money for non-retirement purposes.
For example, $10,000 withdrawn by a 30-year-old will result in a $132,677 reduction at age 65 assuming a 9% investment return. As a matter of fact, a study of Hewitt Associates' data, tabulated by the Employee Benefit Research Institute, shows that among folks in their 30s, 54% took the cash when they left their jobs. Among folks in their 20s, 67% took their lump-sum distribution of cash. For folks in their 50s, 40% took their distributions in cash, but many of those distributions represent folks taking early retirement.
Personally, I believe the best answer is to change the law to prevent distributions when employees change jobs and when plans are terminated.
TB: In my April 25 column I asked readers for their thoughts on how to design a 401(k) plan for employees who earn a substantial portion of income from tips. I received the following answer from one knowledgeable reader. Thanks.
In response to the employer asking how tip employees can contribute to a 401(k) ... We are a restaurant management group with over 2,500 employees, and a large portion of these are tipped servers and delivery drivers. We allow them to "deposit" a portion of their tips to help cover payroll deductions. Payroll deductions are satisfied in the following order: 1) employee payroll taxes, 2) garnishments, 3) insurance deductions, and 4) 401(k). If a tipped employee deposits more of their tips than is necessary to cover their payroll deductions, the remaining amount is "refunded" to them in their paycheck.
Ted Benna, creator of the first 401(k) retirement savings plan, will answer your most intriguing
questions every week. With over 30 years of experience as an employee benefits
consultant, Ted is a nationally recognized expert on benefits issues.
He has authored two books, Helping Employees Achieve Retirement Income Security
and Escaping the Coming Retirement Crisis, and is President of the 401(k)
Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and participants.
His articles and comments have appeared in numerous publications, including The New
York Times and The Wall Street Journal.
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