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401(k) Plans
A
401(k) plan permits employees to choose to defer
a portion of their wages on a pre-tax basis.
The 401(k) plan must be part of a qualified
profit-sharing plan, a stock bonus plan, a pre-ERISA
money purchase pension plan, or a rural cooperative
plan. A 401(k) plan frequently features an "employer
matching" provision in which the employer
makes a contribution to the plan equal to (a
certain percentage of) the employee's contribution.
This serves to encourage participation among
employees at all levels.
The
company usually offers at least four alternative
investment vehicles. Because the law requires
that participation in the plans not be too heavily
skewed towards more highly paid people, companies
generally offer a partial match to encourage
broad participation in these voluntary plans.
This match can be in any investment vehicle
the company chooses, including company stock.
There is a combined limit of 15% of taxable
pay that the company and the employee together
can contribute to the plan. For example, if
an employee is making $30,000 per year and contributed
$2,000 to the 401(k), the combination of the
employee's $2,000 contribution and the company's
match cannot exceed 15% of $28,000 ($4,200).
This 15% limit is further reduced by contributions
to other tax-qualified retirement-oriented benefit
plans.
Some 401(k) plans give employees the choice
of investing in the company they work for. Employers
offer company stock in a 401(k) plan for several
reasons. Some believe that making employees
part-owners of the company will give them incentive
to work harder to make the company succeed,
and a greater feeling of satisfaction when it
does. Also, when employers use company stock
to make matching contributions it is less expensive
for them than using cash, for tax reasons. For
the employee, the tax benefit comes on retirement
- if a distribution of company stock is taken
then, the retired employee will pay income tax
on what the stock was worth when it was acquired,
not what it is worth at the time of withdrawal.
For closely held companies, 401(k) plans are
less appealing, although very appropriate in
some cases. If employees are given an option
to buy company stock, this can often trigger
securities law issues most private companies
want to avoid. Employer matches make more sense,
but require the company to either dilute ownership
or reacquire shares from selling shareholders.
In many closely held businesses, the first may
not be desirable for control reasons and the
second because there may not be sellers. Moreover,
the 401(k) approach does not provide the "rollover"
tax benefit that selling to an ESOP does, and
the maximum amount that can be contributed is
a function of how much employees put into savings.
That will limit how much an employer can actually
buy from a seller through a 401(k) plan to a
fraction of what the ESOP can buy.
The
major benefit to employees of the 401(k) plan
is that they are not taxed currently on the
portion of compensation that is placed in the
plan. An employee has the option of choosing
between cash or future benefits on a year-to-year
basis. In addition to the tax deferral, another
major benefit is that a 401(k) plan is eligible
for five-year averaging on distributions. But,
if an early distribution is taken, the amount
is subject to an additional 10 per cent tax.
Because
a 401(k) plan is a qualified plan, it is subject
to the same rules imposed by the Internal Revenue
Code and ERISA as are all other qualified plans.
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