401k definition: An account set up by an employer for the benefit of their employees’ retirement. Participants may make pre-tax contributions and, if allowed by the Plan, post-tax contributions to their accounts via payroll deductions. Employers have the option of making pre-tax contributions via a match and/or a non-elective contribution, but are not obligated to do so. These contributions offer tax advantages for both employees and employers. Each employee makes their own investment decisions regarding risk and return via the investment options of the Plan.
It’s no wonder why a good 401k definition is hard to come by. Even the IRS, via its website, refers to a 401k not only as a defined contribution plan, which it certainly is, but as a "qualified profit sharing plan," which it may or may not be.
Muddying up the waters even more is the advent of the Roth 401k contribution option. Since 2006, employers have been able to amend their plans to allow after-tax or Roth contributions to 401ks in addition to pre-tax or traditional contributions.
No 401k definition is complete. I might add 401(k) is the sub-section number of the Internal Revenue Taxation Code that created it.
It is also worth noting that ERISA, which stands for the Employee Retirement Income Security Act of 1974, set standards of protection for employee 401(k)s and assigned a fiduciary responsibility upon those that control the Plan assets. It also gives employees the right to sue for benefits and breach of those fiduciary duties.
ERISA legislation comes with a price. The complexities of setting up and maintaining 401(k) plans post-ERISA costs employers’ money. These higher costs often are passed on to employees via an administrative fee.
By abiding by the ERISA rules, the IRS dubs a plan “qualified,” thus making those costs tax deductible by the employer. It’s unfortunate some employers need this “carrot and stick” approach to offer a decent retirement plan, but that’s the way of the corporate world these days.
I’ve examined lots of 401(k) and other employer-offered defined contribution type plans, and I’ve seen some just plain lousy ones. If your company’s plan has high expenses and underperforming investment options, take your match (if any), but invest the rest of your retirement contributions elsewhere.
There are lots of options when it comes to saving for retirement. Your company’s plan should be your primary one if it’s appropriate because the 401k contribution limit is much higher when compared to other tax advantaged accounts.
As mentioned, your employer, as defined by ERISA, has a fiduciary duty – one above and beyond the norm – when it comes to controlling your Plan’s assets. Most company’s efforts stop there.
If you’re lucky, you have a caring employer who offers free financial services. By all means utilize them, but be wary of a conflict of interest. For instance, if the person offering those services works for the company who runs the plan, they may not be telling you everything you need to know.
Your employer’s “default investment option,” where they direct your money unless you indicated otherwise at signup, is not an investment plan. That default option may or may not (probably not) be appropriate for you.
It saddens me when I talk to employees who think that their employers are managing their money for them in these defined contribution plans. That’s just not true.