Companies can offer a variety of goodies to recruit and keep employees. One such bonbon is a qualified retirement plan, such as a 401(k), that allows an employee to sock away part of her annual salary before it's taxed. The pre-tax money is invested and grows without creating current taxes. The employer may kick additional money into a 401(k) account. Generally, an employee can cash out a 401(k) whenever leaving a job.
An employee always gets to keep all the 401(k) money she contributes as well as the earnings on her contributions. An employer can’t take this money away from an employee, even if the employee is fired. As of 2014, employees can contribute annually up to $17,500 of their pre-tax compensation into a 401(k). Employees age 50 or older can contribute an additional $5,500 a year. In some companies, the employer controls how the plan invests contributions, while other companies leave these decisions up to the employee. Even if the employee has some investment control, the employer might limit the choices available to particular mutual funds or other investments.
A 401(k) plan might allow or require employer contributions. These can be matching contributions, in which the employer kicks in a certain amount for each dollar the employee contributes. The other alternative is for the employer to make “nonelective” contributions that aren’t based on the amount an employee puts into the plan. As of 2014, the amount an employer can deposit into an employee’s 401(k) account is limited such that the total of all contributions can’t exceed $52,000, or $57,500 for employees age 50 or older.
“Vesting” is a term that describes when an employee is entitled unconditionally to keep the money in a retirement fund. Employees are always fully vested in their 401(k) contributions and the earnings on those contributions. However, companies may follow a vesting schedule that could deny employer contributions to employees who leave during the vesting period. Federal regulations offer employers two different methods to figure vesting -- the graduated method and the cliff method.
The graduated vesting method requires that 20 percent of employer contributions vest after two years of employee service. After that, another 20 percent vests each year, so that the entire amount is vested by the end of the sixth year following the employer’s contribution. The cliff vesting method permits the employer to wait three years to vest any of its contributions, at which point the full amount is vested. Employer plans may choose faster vesting schedules than those required by regulations.
If an employee wants to avoid paying taxes on the 401(k) money received after being fired, she can roll the amount into an individual retirement account or another retirement plan. The ex-employee must deposit the money into the new account within 60 days after receipt, and the employer must withhold 20 percent of the amount for federal taxes. However if an employee arranges a trustee-to-trustee transfer, the deadline and withholding do not apply. If the money isn’t rolled over and the employee is younger than 59 1/2, the Internal Revenue Service might slap on a 10 percent penalty for early withdrawal.
- The Christian Science Monitor: The 401(k): An Introduction
- Internal Revenue Service: Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits
- U.S. Department of Labor: What You Should Know About Your Retirement Plan
- Internal Revenue Service: Publication 590 Individual Retirement Arrangements
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.