401k Basics

401k plans are defined contribution plans

A 401k plan is what is called a defined contribution retirement savings plan. In defined contribution plans...

  • The amount contributed to each participant's account is set ("defined:) - either by the plan participant or the employer, and as either a flat rate or a percentage of pay.
  • The amount each participant will receive upon retirement is left up to the effect of investment performance on the contributions.

Other defined contribution retirement savings plans include SEPs, Simple IRAs, Profit Sharing Plans and Money Purchase Plans. The 401k is by far the most popular.

Defined contribution plans differ from traditional pension plans, called defined benefit plans, which specify specific amounts of money (the "benefit") employees will receive when they retire rather than the periodic contribution amounts that will be put into the plan to ensure that final benefit amount.

In 401k plans...

  • Each participating employee decides the amount to be withheld as a 401k contribution each month from his or her pay.
  • The employer withholds these amounts BEFORE calculating income taxes on the employee's pay.
  • The employer forwards the money to a third party administrator, who invests the employees' contributions per specific instructions provided by the employees.
  • Some employers choose to add to participants' 401k contributions through employer matching, profit-sharing and/or qualified nonselective contributions; see below for more on employer contribution options and definitions.

The plan sponsor

401k plans must be "sponsored" by an employer. Their very IRS-mandated operation - i.e., that contributions are pulled from employees' pay BEFORE are taxes - is predicated upon the plans being run through the employer.

401k plan sponsorship does not, however, mean the employer must contribute financially to its 401k plan. Please see below, for information on the contribution options - including the option not to contribute - open to plan sponsors.

The Internal Revenue Code allows for retirement savings plans that DO NOT require employer sponsorship; these include annuities and Individual Retirement Accounts (IRAs), but the 401k plan is by far the most popular:

  • 401k plans are extremely convenient for plan participants. Participants simply establish the contribution level they want, then the employer has the amount pulled from the participant's pre-tax pay each period and forwarded to the 401k investments the participant has selected. Participants save money they might spend if it was ever issued to them and left up to them to deposit in their retirement account.
  • 401k plans allow for significantly higher annual contribution levels than IRAs or annuities.
  • Higher contribution levels mean a greater impact on lowering participants' current income taxes.
  • Higher contribution levels mean more money being set aside - and allowed to compound - for retirement.
  • 401k plans can include loan features that allow participants to borrow from their retirement savings. IRAs and most annuities do not offer the possibility of loans.

Plan sponsorship generally entails the employer appointing an in-house person to act as liaison between the plan's vendors and the company's employees. This person is the plan administrator (not to be confused with the outside vendor, if any, providing the overall plan administration; in the case of self-service 401k plans such as 401k Easy, there is no such outside vendor).

The plan vendor

401k plans are supplied by a vendor. The vendor typically supplies the 401k plan itself as well as all related documentation. The vendor deals with the IRS and related governing agencies in making sure the startup plan is consistent with current regulations.

Often the vendor supplies 401k administration services, too. Sometimes the vendor even supplies its own lineup of 401k plan investments.

  • Administration for a 401k plan can be legally supplied almost any party - the plan vendor, the plan sponsor, or any third party - so long as the plan is run in accordance with current regulations.
  • Investments for a 401k plan can be supplied by the plan vendor or by another party, the investment custodian.

Third-party administrators

Legally speaking, administration for a 401k plan can be supplied almost any party — the plan vendor, the plan sponsor, or a third party - so long as the plan is run in accordance with current regulations, among them IRS compliance testing stipulations.

  • Third-party administrators (TPAs) are often contracted by 401k vendors or by the 401k plan sponsors themselves to handle a 401k plan's month to month administration.
  • Plan sponsors (i.e., the employers) supply the third-party administrators with payroll and related 401k participation data (such as loan and distribution requests) each month. The TPA processes the data and instructs the plan sponsor regarding forwarding 401k monies to the appropriate investment custodian(s).
  • 401k Easy is like a plan sponsor's personal third-party administrator. The system handles all plan administration or the payroll and related data the plan sponsor feeds it, and it supplies the plan sponsor with instructions regarding forwarding monies to the appropriate investment parties. Visit our Plan Sponsor Gateway Demo for more about 401k Easy's self-service plan administration.
  • 401k Easy handles your plan participant, requests, too - at any time, day or night, any day of the week. Visit our Plan Participant Gateway Demo for more about 401k Easy's self-service plan participation.

Auto enrollment

The 401k "auto enrollment" procedure allows employers to AUTOMATICALLY enroll employees in the 401k plan as soon as the employee meets the plan's eligibility requirements. Employees can elect to decline enrollment at any time.

  • The employer must set the auto enrollment contribution level in advance; 3% to 5% of compensation is the typical auto enrollment contribution level chosen.
  • The employer must set an auto enrollment investment selection ahead of time; a money market fund is the most typical auto enrollment investment.
  • Employers must, at least annually, notify all company employees that the company 401k uses the auto enrollment feature and how an employee can cease participation in the plan or put a block on being enrolled automatically in it.
  • Employers must immediately notify auto-enrolled employees of their new 401k participation status.
  • Any employer contributions being made to traditionally-enrolled participants' accounts must also be made to auto-enrolled participants' accounts.
  • Auto-enrolled plan participants must have the opportunity to change their default investment selection and/or contribution rate.
  • If an automatically-enrolled employee soon-after cancels his or her participation in the plan, any money put into the plan on the person's behalf must stay in the plan until the person's employment is terminated or the employee reaches age 65. At that point, the employee has the same withdrawal choices (IRA rollover, rollover into another employer's qualified retirement plan, or distribution) as any 401k participant of the same age and employment status.

Automatic enrollment is also called "passive enrollment" and "negative enrollment"; the default contribution and investment designations are called the plan's "negative elections."

The IRS approved negative elections relatively recently; certain legalities outside of the scope of the IRS remain undefined, so prudence says to consult a legal advisor before adopting automatic enrollment for your 401k plan.

Employee contributions

Contributions to a 401k account can come from employees and/or their employers. Employee contributions are withheld from the participant's pay BEFORE income tax withholding is calculated. Thus, 401k contributions are pre-tax contributions.

  • Employees can also "rollover" (aka, transfer) money into their current 401k from their account in their previous employer's 401k. Consolidating accounts can simplify oversight and management of a comprehensive investment strategy under the direction and control of the plan participant.
  • Participating in a 401k plan can reduce a person's lifetime income tax burden, because income taxes aren't assessed on 401k contributions until the money is withdrawn from the plan, usually years down the road, during retirement, when the participant is likely in a lower income tax bracket.

Employees cannot contribute more than 15% of their annual earnings to their 401k account. Additionally, they cannot contribute more than an annually-adjusted total dollar amount of their annual earnings to their 401k account.

  • These limits apply to employee contributions only.
  • Employer contributions to an employee's account can take the total annual contribution amount much higher.
  • Returns earned on 401k investments are never included in these annual contribution limits and can be a substantial source of growth for a 401k account.

Employer contributions

Contributions to a 401k account can come from employees and/or their employers. Employers choose whether or not to contribute to their employees 401k accounts. If they choose to contribute, they can do so in any of three ways:

  • At a flat fixed-dollar amount to each participant's account (e.g., $500 to each participant's account each year).
  • At a fixed rate of each participant's pay (e.g., each participant gets an amount equal to 3% of his or her salary). This is called a profit sharing contribution or a discretionary employer contribution.
  • At a rate that depends on how much the employee contributes to the 401k plan, This is called a matching contribution. Because matching contributions depend on the employee's level of participation (25¢ for every dollar the employee contributes, for example), they encourage employees to join the 401k, contribute as much money as they can, and stay with the company over the years in order to continue participating in the company plan.
  • Employers are NOT required to contribute to their employees' 401k accounts in any way. Employer contributions are completely voluntary on the part of the employer (unless being used to satisfy a plan imbalance, in which case qualified nonselective contributions might be made to, say, all non highly compensated employees' accounts).

Any employer qualified nonselective contributions are 100% vested to employees when made. Employer matching and profit sharing contributions, on the other hand, do not have to immediately become the property of the employees. Instead, employers can impose a vesting schedule by which the 401k participants gain full ownership of employer contributions incrementally, over time. For example...

  • An employer chooses to make matching contributions of 25¢ to each dollar plan participants contribute. This is called the matching formula.
  • The employer stipulates that people who have participated in the plan two years or less only get 25% ownership of these employer-provided matching contributions. People who have participated in the plan three years get 50% ownership of the matching contributions. People who have participated in the plan four years get 75% ownership of the matching contributions, and people who have participated in the plan five years or more get 100% ownership of matching contributions. This schedule of ownership is an example of a vesting formula. It is relevant if a participant leaves the plan before reaching fully vested status. Any non-vested employer contributions revert back to the plan and can be used to pay matching contributions owed to other participants.
  • The Internal Revenue Code places dollar amount ceilings and other restrictions on matching and vesting formulas.

401k contribution guidelines and limitations

Federally mandated limitations govern how much an employee can contribute to his or her 401k plan each year, and how much the employer can likewise contribute to the company's plan. The following information and examples are provided by the IRS:

401(k) Resource Guide - Plan Participants - Limitation on Elective Deferrals

There is a limit on the amount of elective deferrals that you can contribute to your traditional or safe harbor 401(k) plan.

  • The limit is $17,500 for 2014 and $18,000 for 2015.
  • The limit is subject to cost-of-living increases after 2015.

Generally, all elective deferrals that you make to all plans in which you participate must be considered to determine if the dollar limits are exceeded.

Limits on the amount of elective deferrals that you can contribute to a SIMPLE 401(k) plan are different from those in a traditional or safe harbor 401(k).

  • The limit is $12,000 for 2014 and $12,500 for 2015.
  • The limit is subject to cost-of-living increases after 2015.

Although, general rules for 401(k) plans provide for the dollar limit described above, that does not mean that you are entitled to defer that amount. Other limitations may come into play that would limit your elective deferrals to a lesser amount. For example, your plan document may provide a lower limit or the plan may need to further limit your elective deferrals in order to meet nondiscrimination requirements.

Catch-up contributions. For tax years beginning after 2001, a plan may permit participants who are age 50 or over at the end of the calendar year to make additional elective deferral contributions. These additional contributions (commonly referred to as catch-up contributions) are not subject to the general limits that apply to 401(k) plans. An employer is not required to provide for catch-up contributions in any of its plans. However, if your plan does allow catch-up contributions, it must allow all eligible participants to make the same election with respect to catch-up contributions.

If you participate in a traditional or safe harbor 401(k) plan and you are age 50 or older:

  • The elective deferral limit increases by $5,500 for 2014 and $6,000 for 2015.
  • The limit is subject to cost-of-living increases after 2015.

If you participate in a SIMPLE 401(k) plan and you are age 50 or older:

  • The elective deferral limit increases by $2,500 for 2014 and $3,000 for 2015.
  • The limit is subject to cost-of-living increases after 2015.

The catch-up contribution you can make for a year cannot exceed the lesser of the following amounts:

  • The catch-up contribution limit, above, or
  • The excess of your compensation over the elective deferrals that are not catch-up contributions.

Participation in plans of unrelated employers. If you participate in plans of different employers, you can treat amounts as catch-up contributions regardless of whether the individual plans permit those contributions. In this case, it is up to you to monitor your deferrals to make sure that they do not exceed the applicable limits.

Example: If Joe Saver, who’s over 50, has only one employer and participates in that employer’s 401(k) plan, the plan would have to permit catch-up contributions before he could defer the maximum of $24,000 for 2015 (the $18,000 regular limit for 2015 plus the $6,000 catch-up limit for 2015). If the plan didn’t permit catch-up contributions, the most Joe could defer would be $18,000. However, if Joe participates in two 401(k) plans, each maintained by an unrelated employer, he can defer a total of $24,000 even if neither plan has catch-up provisions. Of course, Joe couldn’t defer more than $18,000 under either plan and he would be responsible for monitoring his own contributions.

The rules relating to catch-up contributions are complex and your limits may differ according to provisions in your specific plan. You should contact your plan administrator to find out whether your plan allows catch-up contributions and how the catch-up rules apply to you.

Treatment of excess deferrals. If the total of your elective deferrals is more than the limit, you can have the difference (called an excess deferral) returned to you from any of the plans that permit these distributions. You must notify the plan by April 15 of the following year of the amount to be paid from the plan. The plan must then pay you that amount plus allocable earnings by April 15 of the year following the year in which the excess occurred.

Excess withdrawn by April 15. If you withdraw the excess deferral for 2014 by April 15, 2015, it is includable in your gross income for 2014, but not for 2015. However, any income earned on the excess deferral taken out is taxable in the tax year in which it is taken out. The distribution is not subject to the additional 10% tax on early distributions.

Excess not withdrawn by April 15. If you do not take out the excess deferral by April 15, 2015, the excess, though taxable in 2014, is not included in your cost basis in figuring the taxable amount of any eventual distributions from the plan. In effect, an excess deferral left in the plan is taxed twice, once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan may not be a qualified plan.

Reporting corrective distributions on Form 1099-R. Corrective distributions of excess deferrals (including any earnings) are reported to you by the plan on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Additional limits. There are other limits that restrict contributions made on your behalf. In addition to the limit on elective deferrals, annual contributions to all of your accounts - this includes elective deferrals, employee contributions, employer matching and discretionary contributions and allocations of forfeitures to your accounts - may not exceed the lesser of 100% of your compensation or $52,000. In addition, the amount of your compensation that can be taken into account when determining employer and employee contributions is limited. In 2014, the compensation limitation is $260,000; for 2015, the limit is $265,000

401k investments

Certain types of investments are "qualified" under the Internal Revenue Code to receive 401k contributions. These include:

  • Mutual fund investments (stocks, bonds and money market funds). Mutual fund investments are by far the most popular 401k investments.
  • Publicly traded stocks and bonds (excepting municipal or tax free bonds)
  • Bank collective funds
  • Insurance company investments

Every 401k plan must offer a minimum spectrum of investments, as defined in the Internal Revenue Code.

  • Most plans offer between five and 15 investment choices.
  • Returns earned on 401k investments are automatically reinvested in the participants' accounts, increasing the account value over time.
  • Removing investment returns from a 401k, just like removing any other money from a 401k account, constitutes a withdrawal and is subject to the penalties and withholdings of such.

With 401k Easy you have an unlimited selection of 401k investments.

401k investing and tax-deferred saving

All 401k contributions - employee, employer and even returns earned on 401k investments - are exempt from income taxation (in most cases state, in all cases federal) so long as the money remains in the plan. Delaying income taxation can have a dramatic positive effect on the compounding growth of an account:

  • An investor can amass nearly THREE TIMES as much money in a 401k tax-deferred investment over a 30 year period as in a taxable savings plan or investments earning the same rate of return but whose returns are reduced each year by income taxation.
  • When money is taken out of a 401k plan - for ANY reason except a 401k loan (see next topic) or rollover into an IRA or new employer's 401k plan - it is considered income and taxed as such.

Withdrawals and 401k loans

Although 401k plans are meant to be long term savings vehicles, participants cannot leave money in a 401k account indefinitely:

  • Plan participants generally MUST begin taking withdrawals from their 401k accounts when they reach age 70 1/2.
  • Plan participants CAN begin taking withdrawals from their 401k accounts as soon as they reach age 59 1/2.
  • Earlier withdrawals can be made without penalty if the participant dies or incurs a qualifying permanent disability.
  • At any time, a plan participant leaving the company can remove his or her 401k money without subjecting it to early withdrawal penalties by rolling the money over into a Rollover IRA or new employer's qualified retirement savings plan (401k or other).

Outside of these instances, there are only two ways for participants to withdrawal money from a 401k account while employed: hardship withdrawal and 401k loan.

  • Hardship withdrawals differ markedly from 401k loans. For instance, hardship withdrawals don't have to be paid back (loans do) BUT the money withdrawn is subjected to substantial early withdrawal penalties (not the case with 401k loans).

To view in a secondary window a chart briefly comparing hardship withdrawals with 401k loans, click here.

401k loans are not discharged in bankruptcy (the participant's bankruptcy). Also, it is permissible for an employer or court to ensure repayment of such loans through payroll withholding.

Hardship withdrawals and 401k loans can increase a plan's popularity even if participants never take advantage of the features, because employees don't feel participation means sending their money into some seemingly never-to-be-seen-again abyss. Retirement, after all, may be decades away.

  • As with any of your 401k Easy plan and plan administration customization choices, if you'd like help understanding more about this option and its typical effects on a 401k plan of your company's size, just contact us with your question.

ERISA participant rights protections

Two bodies of legal work comprise the framework for 401k plans: the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA).

ERISA sets standards for, among other things...

  • Participant eligibility
  • Investment choice
  • Plan funding/bonding
  • Vesting of employer contributions
  • Disclosure of plan and investment and investing-related information to current and prospective plan participants and their beneficiaries

ERISA aims to ensure that retirement monies actually exist at employees' retirements by preventing fund mismanagement by administrators, trustees and others. An employer interested in purchasing an ERISA bond for the company's 401k typically buys a bond that covers 10% of the plan's total assets. ERISA bonds are very economical and easy to buy. Most insurance agents offer these bond's to small companies at very low annual rates.

Fiduciary Liability Insurance - Fiduciary liability insurance is different than an ERISA bond. Fiduciary liability insurance is a completely discretionary purchase on the part of the employer; it provides broad coverage for all persons who are de facto "fiduciaries" of the company's plan. A fiduciary is someone who provides investment advice to the plan for a fee, and/or has discretionary control or authority over the administration of the plan, and/or who has authority or control over plan assets. (note: NASD Registered Representatives are not considered fiduciaries; they earn commissions on plan assets and typically do not charge fees for investment advice.)

Fiduciary liability insurance is very inexpensive; the cost is approximately five 5 percent of the coverage limits purchased, unless the company offers its own stock as an investment option, which increases the premium. Coverage is broad, and the only exclusions are for deceptive practices and fraud, which is covered by the ERISA bond. Providers of fiduciary liability insurance coverage include American International Group (AIG); Chubb Executive Risk; Lloyd's of London; Reliance Insurance; and Travelers Property Casualty.

IRS compliance testing

To prevent employers from designing 401k plans that economically benefit only highly-paid personnel, lawmakers wrote compliance test mandates into the rules governing 401k plans.

  • In general, no plan can be set up in a way that discriminates "as to the availability of rights, benefits and features" available to different employees under the plan.


  • Every 401k must pass mandated compliance testing every year. The tests compare the participation rates of different classes of employees (see below).
  • Beginning in 1999, employers can choose to skip the tests and instead make a requisite contribution to their so-called non-highly-compensated employees' 401k accounts. This is called the safe harbor method of plan administration (see below).
  • Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution (explain), the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.

Not correcting a failed year-end compliance test can mean substantial penalties and possibly even disqualification of the plan's tax-exempt status. Test failures can be VERY expensive in terms of IRS penalty fees, man-hours spent trying to correct the problems and lost rapport with your employees, who may have to amend and refile their income tax forms -- and often pay additional income taxes, too.

The most common compliance tests are the ADP test, ACP test, and top-heavy test.

  • The ADP test (Actual Deferral Percentage test) compares the percentage of salaries that different classifications of employees are diverting into the 401k plan.
  • The ACP test (Actual Contribution Percentage test) compares the percentage of employer contributions being diverted into the 401k accounts of different classifications of employees.
  • The top-heavy test looks at the degree to which higher-paid employees' money dominates the 401k plan.

Safe Harbor 401k Plan Administration

401k compliance tests are designed to ensure 401k plans have a threshold balance, at minimum, of participation of rank-and-file employees in relation to highly-paid employees.

The IRS offers an alternative means of achieving 401k plan balance: The safe harbor method of plan operation lets 401k plans skip their annual 401k discrimination testing so long as the sponsoring employer meets certain employer 401k contribution requirements designed to ensure broad participation in the company plan and provides 100% immediate vesting of the contributions.

  • To qualify a 401k plan as a safe harbor plan, an employer must make matching contributions that fulfill the below requirements or make nonselective contributions equal to 3% of each eligible employee's compensation.
  • nonselective contributions are made to all eligible employees, regardless of if the employees participate in the company 401k plan. Matching contributions, on the other hand, being based upon salary deferral amounts, are made only to active 401k participants' accounts.
  • If the employer chooses to make safe harbor matching contributions, those contributions must meet two requirements: First, each non-highly-compensated employee must receive a dollar-for-dollar match on salary deferrals up to 3% of compensation and a 50¢ to the dollar match on salary deferrals from 3% to 5% of compensation. Second, the rate of any matching contributions being made to highly compensated employees cannot exceed that being made to non-highly compensated employees.

The employer must provide annual information to employees explaining the 401k plan's safe harbor provisions and benefits, including that safe harbor contributions can not be distributed before termination of employment and that they are not eligible for financial hardship withdrawal.

Employers can decide as late as 30 days before the end of each plan year whether or not to take the safe harbor route. However, if, as its safe harbor contribution, the employer wants to make matching contributions rather than the flat 3% of compensation contribution, the employer must define the matching formula well ahead of those 30 days; in fact, any safe harbor matching contribution must be defined and communicated to employees no later than 30 days before the START of the applicable plan year so employees have plenty of time to adjust their contribution rates accordingly.

Your 401k Easy system includes such notification within your customized 401k plan's Summary Plan Description, a document that's updated at least annually for all eligible employees.

  • If you don't choose the safe harbor method of 401k plan administration, we encourage you to use your customized 401k plan administration software's point-and-click compliance testing every month to keep well apprised of your plan's health.

Economic growth and tax reconciliation act of 2001 (EGTRA)

The Economic Growth and Tax Reconciliation Act of 2001 made several pertinent changes to federal 401k regulations. To view a secondary window listing the changes click here; unless otherwise stated, the EGTRA amendments took effect January 1, 2002.

401k-type plans for one-person businesses

The one-person 401k is now a regulatory reality. Below is information about 401k plans for an individual (and his or her spouse). To read about our one-person 401k plan and plan administration product, which, like all our products, offers that desirable duo of affordability + investment flexibility, see our 401k Easy for One section within our Products page.

The 401k plan's popularity lies in that it enables people to shelter a significant portion of their income from current income taxes. In some cases, a 401k plan enables a person to shelter more than twice as much as do other qualified retirement plans (money purchase pension plans, simplified employee pension (SEP) plans and savings incentive match plans for employees (SIMPLEs), more specifically). Until recently, however, a 401k plan needed multiple plan participants. It was not an option for one-person companies and the like - again, that is, until 2002. The one-person 401k plan is now a reality.

An estimated 18 million one-person business owners are eligible to participate in one-person 401k plans. Eligible businesses include corporations, sole proprietorships and non-profit organizations. From the accountant to the lawyer, doctor, software programmer and real estate agent, among others, who hangs his or her own shingle, the one-person 401k is now a possibility.

One-person 401ks are designed for owner-only businesses (including spouse) and businesses with employees who can legally be excluded from participation using federal plan coverage requirements.

The One-Person 401k's Advantages Over SEP IRAs and SIMPLE IRAs
One-Person 401k plans can be used for incorporated and unincorporated businesses, including C corporations, S Corporations, single member LLCs, partnerships and sole proprietorships. Real estate brokers, consultants, attorneys, manufacturers representatives, interior designers, retirees starting a new business and other professionals who work by themselves are prime candidates.

Under rules created by changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that became effective in January 2002, a business consisting of only an owner or an owner and his or her spouse, can make greater tax-deductible contributions in a one-person 401k than under a SEP-IRA or SIMPLE IRA. Contributions are discretionary, so owners can vary them from year to year or skip them altogether.

Total tax-deferred contributions to a one-person 401k cannot exceed 100% of pay, up to a maximum of $41,000 for people younger than age 50. This amount includes salary deferrals of up to $13,000 ($16,000 if age 50 or older) plus an employer contribution of up to 25% of pay (20% for self-employed). While SEP-IRA contributions also max out at $41,000, they are limited to 25% of pay (20% for self-employed). And, SEP-IRAs do not provide for additional catch-up contributions. With a SIMPLE IRA, employees under age 50 can defer up to $9,000 this year, while those age 50 or older can contribute up to $10,500. The employer can make additional required contributions.

Under these guidelines, a business owner under age 50 with earned income of $100,000 who is the sole employee of his business could contribute a maximum of $25,000 to a SEP-IRA, $12,000 to a SIMPLE IRA, and $38,000 to a one-person 401k (consisting of a $13,000 salary deferral plus an employer contribution of $25,000). Someone with $150,000 in W-2 income could contribute as much as $37,500 to the SEP-IRA, $13,500 to the SIMPLE IRA, and $41,000 to the one-person 401k.

The ability to make generous contributions at lower income levels means that business owners who want to catch-up on retirement contributions can do so more quickly than they could with a SEP-IRA or a SIMPLE IRA. Someone in his 50s with $100,000 in income could put away $41,000 for retirement this year with a one-person 401k; that amount of tax-deferral is not possible with a SEP or SIMPLE IRAs.

Retirement plan experts say that investment flexibility, and possible increased protection of personal assets from litigation, in addition to higher contribution levels, are additional the major draws of one-person 401k plans. The plans can accept rollovers from virtually any type of retirement plan, including a corporate 401k or an IRA. Business owners can also borrow the lesser of 50% of the plan balance, or $50,000. Loans are not allowed from SEP and SIMPLE IRAs, or IRA Rollovers.

The one-person 401k loan feature is a powerful advantage for business owners who may need quick, short-term access to their money without incurring the taxes and penalties associated with taking an early distribution from a rollover IRA. A lot of people are using a one-person 401k to consolidate existing retirement accounts, then borrow against the plan.

For someone under age 59 ½ who has left a job and is strapped for cash, the loan feature can be a way to get money out of a 401k without facing the penalties and taxes associated with a premature retirement plan distribution. The only requirement to establish an account is that you have self-employment income; a person between jobs and doing consulting work would qualify. Loans must be repaid according to IRS guidelines, as they would with a corporate 401k, or they become subject to taxes and penalties.

When considering establishing a one-person 401k, look for:

  • A broad spectrum of no-load investment options.
  • The option to use a self-directed discount brokerage account.
  • A loan feature, as that may come in handy in a family emergency.
  • The ability to easily and affordably convert to a standard 401k should your business grow to where you are adding employees and want them to be able to participant in the company 401k plan.

401k retirement plans are excluded from bankruptcy estates

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 excludes from the bankruptcy estate retirement funds that are exempt from taxation under the Internal Revenue Code (the "Code"); this includes 401k plans, profit sharing plans, defined benefit plans and IRAs. In addition, the Act protects tax-exempt retirement funds that are transferred to another tax-exempt retirement fund (i.e., a rollover to an IRA).

The Act provides a limited exemption of $1,000,000 to traditional and Roth IRAs. The debtor may petition the bankruptcy court for protection beyond that limit, and the court may grant the relief "if the interest of justice so requires." The benefits in IRA-based retirement plans, such as simplified employee pension plans (SEPs) or simple retirement accounts (SIMPLEs), are fully protected (the dollar limit does not apply to those plans).

As a practical matter, IRA holders often commingle rollover and traditional contributions in a single IRA. Under the Act, rollover contributions have unlimited protection if they came from tax-exempt funds. For this reason, IRA holders should account separately for those funds. The most prudent approach may be to put them in a separate IRA.

It should be noted that the Act clarifies that participant loans are not discharged in bankruptcy if they are owed to a pension, profit-sharing, stock bonus or other tax-exempt deferred compensation arrangement. And, it is permissible to ensure repayment of such loans through payroll withholding.

The Act is significant because it excludes from the bankruptcy estate a much broader range of tax-exempt retirement arrangements than prior law. The Act, too, provides specific federal authority for exempting IRAs from bankruptcy estates. Historically, IRAs were thought to be subject to the claims of bankruptcy creditors - at least under federal law (many states had given full or partial protection to IRAs). More recently, the U.S. Supreme Court held that there was limited protection for IRA benefits.

Overall, the new law affords greater asset protection of particularly beneficial to corporate officers, directors and other higher-compensated individuals. The Act became effective October 17, 2005, and does not apply to any bankruptcy cases filed prior to that effective date. Its protections apply only if the participant has filed for bankruptcy.



12b-1 Fees

The maximum charge deducted from fund assets to pay for distribution and marketing costs. Charged to investors. Usually assessed as a percentage of assets held, although sometimes as a flat amount; methodology is listed in the fund's prospectus. Sometimes called a management fee, although distinct from annual management fees.


Annual management fee

Annual fee charged by the mutual fund company to investor to, in part, pay the professional fund manager of the investment. Usually range from 0.25% to 1.5% of assets held. Deducted automatically from investors' accounts. Higher management fees do not assure superior fund performance.

Asset allocation fund

Income and capital appreciation are dual goals for funds with this objective. Managers often use a flexible combination of stocks, bonds and cash; some, but not all, shift assets frequently based on analysis of business-cycle trends.

Automatic enrollment

(see Passive Enrollment, below)


Back-End load

The sales charges assessed when the investor removes money from the investment. Generally declines with the time the investors own the shares. Usually starts out at 6% for the first year and gets smaller each year thereafter until it reaches zero (usually in the sixth or seventh year of owning the investment). Also called a deferred load, deferred sales charge or exit charge. Back-end loads are used primarily to pay a commission to the broker/dealer who sold the fund to the investor. Often coupled with 12b-1 fees.

Balanced fund

Seek both income and capital appreciation by investing in a generally fixed combination of stocks and bonds. These funds generally hold a minimum of 25% of their assets in fixed-income securities at all times.


A historical measure of the magnitude of a portfolio's past share-price fluctuations in relation to the ups and downs of the overall market (or appropriate market index). The market (or index) is assigned a beta of 1.00, so a portfolio with a beta of 1.20 would have seen its share price rise or fall by 12% when the overall market rose or fell by 10%.

Bond fund

Mutual funds that have higher risks than money market funds but seek to pay higher yields. Not restricted to high-quality or short-term investments (as are Money Market Funds). Because there are many different types of bonds, bond funds can vary dramatically in their risks and rewards. Long-term bond funds invest in bonds with longer maturities (a longer length of time until final payout). The values of long-term bonds can go up and down more rapidly than those of shorter-term bond funds.


An investment professional licensed by the National Association of Securities Dealers to act as the liaison between buyers and sellers of securities.

Bundled plan

A 401k investment-administration-plan package sold as one unit. In contrast to a basic 401k plan, in which the employer can individually hire the investment provider and administration provider as he or she chooses. In most bundled plans, no variation from the standard is allowed; in others, such as 401(k) Easy, there's immense investment selection as well as many variable features you choose among to customize your 401k plan to the needs of your company and its employees.


Class A fund

Mutual fund investments that generally charge a front-end load, the size of which usually runs inverse to the amount of money being invested.

Class B fund

Mutual investments that generally charge a back-end load that declines with the amount of time the person holds the investment fund.

Class C fund

Mutual fund investments that generally function similarly to Class B shares, but with a back-end load that's typically lower. Class C management fees, however, are typically higher than those for Class B or Class A shares.

Compliance test

IRS-mandated tests that compare contribution levels and actual amounts made by different classifications of plan participants. The most common tests 401k plans must pass each year as of 2002 are the ADP Test (Actual Deferral Percentage), ACP Test (Actual Contribution Percentage), and Top-heavy Test.

Corporate bond fund-general

Seeks income by investing in fixed-income securities, primarily investment-grade corporate bonds.

Corporate bond fund-high yield

Seeks income by generally investing 65% or more of assets in bonds rated below BBB. The price of these issues is generally affected more by the condition of the issuing company (similar to stock) than by the interest rate fluctuation that usually causes bond prices to move up and down.


Declining load

A purchase or liquidation fee that goes down either in conjunction with the amount of time the person has held the mutual fund shares or with the amount of shares the person owns.

Deferred fees

See Back-End Load.

Discrimination testing

See Compliance Tests.


Emerging growth fund

Seeks rapid growth of capital and that may invest in emerging market growth companies without specifying a market capitalization range. They often invest in small or emerging growth companies and are more likely than other funds to invest in IPS's or in companies with high price/earnings and price/book ratios. They may use such investment techniques as heavy sector concentrations, leveraging and short-selling.

Equity-income fund

Funds expected to pursue current income by investing at least 65% of their assets in dividend-paying equity securities.


Employee Retirement Income Security Act of 1974, legislation designed to protect the rights of the plan participants and beneficiaries.

Exit charge

See Back-End Load.

Expense ratio

The annual fee charged to mutual fund shareholders (usually as a percentage of total investment) for the administration, operation and management expenses associated with a particular fund. May include management fees, 12b-1 fees and other fees, but does not include sales charges. Shows the actual amount that a fund takes out of its assets each year to cover its expenses.



The person who provides investment advice to a company's qualified retirement plan for a fee, and/or has discretionary control or authority over the administration of the plan, and/or has authority or control over the assets of the plan.

Foreign stock fund

Funds that invest primarily in equity securities of issuers located outside of the United States.

Form 5500

The Form 5500 is required by the IRS and Department of Labor annually. The 5500 provides statistical information about the plan and plan sponsors, reports financial information about the plan, and demonstrates compliance with 401k rules.

Front-end load

A fee assessed at the purchase of mutual fund shares, usually as a percentage of the purchase dollar amount. By law cannot be higher than 8.5% of the amount being invested. Front-end loads go to pay a commission to the broker who sold the fund, in theory in exchange for the broker giving the investor professional advice.

Full-service plan

In the context of this web site, a full-service plan is any 401k plan in which you pay people outside of your company to provide the plan's administration, investments and other services. One or more companies may take care of these duties, depending on the plan and its provider.

Fund family

A company that offers mutual funds. Generally, the company name is included in the official fund name.

Fund manager

The person(s) whose job it is to "manage" the investment by buying and selling securities with the goal of having the investment meet the growth and other Objectives stated in the prospectus within the constraints (conservative growth, moderate growth, etc.) also stated in the prospectus; investors are credited with profits/losses from these transactions in proportion to the number of shares they own.


Government bond fund-general

Offerings that pursue income by investing in a combination of mortgage-backed securities, treasuries and agency securities.

Growth fund

Funds that pursue appreciation by investing primarily in equity securities. Current income, if considered at all, is a secondary concern.

Growth and income fund

Growth of capital and current income are near-equal objectives for these funds. Investments are typically selected for both appreciation potential and dividend-paying ability.


Highly-compensated employee

Highly-compensated employees are defined by the IRS as persons who own 5% or more of the company and/or earn more than $170,000 annually, and/or earn more than $85,000 (to be adjusted in 2002) in the prior year and are in the top 20% of the company, ranked by pay.



Hypothetical portfolio (common examples are; Dow Jones Industrials, and S&P 500) The performance of which is often used as a benchmark in judging the relative performance of securities such as mutual funds, stocks, and variable annuity sub-accounts. Indexes are unmanaged portfolios and should only be compared with securities or mutual funds with similar investment characteristics and criteria.


Load (load fund)

Mutual fund investments that charge either a front-end (purchase) or back-end (liquidation) fee on shares.


Management fee

See Annual Management Fee.

Money market fund

A relatively low-risk mutual fund (when compared with others) managed to maintain a stable $1 share price/NAV. Investments in these funds are neither insured not guaranteed by the US government, and there can be no assurance that a fund will be able to maintain a stable net asset value of $1 per share.

Mutual fund

A collection of money invested in a group of assets and managed by an investment company (a mutual fund company or other). The money comes from investors who want to buy shares in the fund. The benefits to investors in buying shares of mutual funds come primarily from diversification, professional money management, and capital gains and dividend reinvestment.

Mutual fund company

A company that brings together money from many people and invests the money in stocks, bonds or other securities. The combined holdings of the stocks, bonds and other securities and assets the fund owns are known as its portfolio. Each investor owns shares of the portfolio; each shares represents a percentage ownership in the portfolio holdings.


Net asset value (NAV)

The per share market value (price) of a mutual fund; in general, the price offered to purchase one share of the mutual fund. The NAV in most cases is calculated b including the closing day's prices of all securities held in a particular fund, plus all other assets owned by the fund (including cash), subtracting all liabilities of the fund, and then dividing the sum by all the outstanding shares of the fund on that given day. If the fund is a no-load fund, then the offering per share price for the fund and the NAV per share will be the same.

Negative elections

See Passive Enrollment.

No-load fund

Mutual fund investments that do not charge front-end (purchase) or back-end (liquidation) fees; load mutual funds do, however, involve annual management fees.


Passive enrollment (aka, automatic enrollment, negative elections)

When employees are automatically enrolled in the 401k plan as soon as they meet the plan's eligibility standards. Default investments (usually a money market fund) and a default contribution rate (usually 3% to 5% of the person's compensation) are preset by the employer. All passively enrolled employees must be immediately notified of their new 401k participant status, and they must be given the opportunity to change from the default contribution rate and/or investment selection (and, of course, given the opportunity to withdraw from the plan entirely). The small amount of money that was placed in the 401k for a new employee who cancels participation soon after automatic enrollment must stay in the plan until the person's employment is terminated.

Plan sponsors

The person (typically the employer) who is responsible for adopting the plan and sponsoring it for the benefit of the employees.

Plan vendors

Companies that sell 401k plans that are pre-packaged or bundled.


The combined holdings of stocks, bonds or other securities and assets a mutual fund company owns. Also, the combination of stocks, bonds and other securities and assets an individual person owns.


A printed document for investors that describes a particular mutual fund investment; needs to explain the overall investment goals, how the fund manager expects to meet those goals, any management fees charged to investors, the investment's historical returns and projections for the future.



A transfer from one qualified tax-deferred pension plan (such as a 401k plan) into another (such as a new employer's 401k plan) that does not expose the money to early withdrawal penalties nor income taxation. An IRA rollover is a common choice for employees leaving a company: the money goes from the former employer's 401k into an Individual Retirement Account (IRA), where it continues to grow and compound tax-free.

Russell 2000

Measures the performance of the 2,000 smallest companies in the Russell 3000 index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. As of the latest reconstitution, the average market capitalization was approximately $421 million; the median market capitalization was approximately $452 million. The largest company in the index had an approximate market capitalization of $1.0 billion. The stocks represented by this index involve investment risk which may include the loss of principal.


S&P composite

A market capitalization weighted price index composed of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange and Over-The-Counter market. The value of the index varies with the aggregate value of the common equity of each of the 500 companies. The stocks represented by this index involve investment risks which may include the loss of principal invested.

Sales charge

A fee charged when new shares of a mutual fund are purchased. It is sometimes called a load, front-end load, or exit charge. Mutual funds that don't have sales charges are called no-load funds.

Service requirement

The service requirement is the minimum amount of time that an employee must work for you, before he is eligible to participate in the plan.


Short for shares of a mutual fund investment. Each investors owns a percentage of the investment, as represented by the number of shares owned in relation to the number of shares issued.

Specialty fund

Funds that invest primarily in equity securities of issuers within a narrow industrial category. (i.e., automotive, travel, electronics, etc.)

Stock funds (aka, equity funds)

Mutual funds that generally involve more risk than Money Market or Bond funds -- but they also can offer the highest returns. A Stock Fund's value (NAV) can rise and fall quickly over the short term, but historically stocks have performed better over the long term than other types of investments. Not all stock funds are the same (e.g., Growth Funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains; other specialize in a particular industry, such as technology).

Summary annual report (SAR)

The SAR is a recap of the financial activity that occurred in the 401k during the plan year. The SAR must be distributed to each participant and beneficiary within nine months after the close of the plan year. For sample Summary Annual Reports, including ready-to-complete PDFs, please see our 401k FedForms web site.

Summary plan description (SPD)

The SPD is an overview of the rules and benefits of a 401k plan. The DOL requires the plan administrator provide a copy of the SAR to each employee participating in the plan.


Third-party administrator

A company that provides plan administration and record keeping services to a plan sponsor. The third-party administrator may also provide investments to the plan.

Ticker symbol

The letters assigned to a particular stock, option or mutual fund used to identify that particular security for trading or quoting purposes.



The portion of a participant's 401k account balance that they are entitled to under the plan's rules. Depending on the provisions of the plan, employees become "vested" over a pre-determined period of time, incrementally over a period of years.


World bond fund

Seek current income with capital appreciation as a secondary objectives by investing primarily in debt obligations issued throughout the world. These bonds are frequently foreign government issues.

World stock fund

Funds that invest primarily in equity securities of issuers located throughout the world, while maintaining a percentage of assets (normally 25% to 50%) in the United States.

Wrap fee

A charge for an investment program that bundles or "wraps" together a number of services (such as brokerage, advisory, research, consulting, and management services) and covers them with a single fee. Typically the wrap fee is based on the value of 401k assets being managed.