The Mechanics of Your 401(k)

401(k) plans, which are sponsored by companies for the benefit of their employees, have grown in popularity and with such speed in recent years that they are rapidly displacing traditional defined benefit pension plans. Technically, the 401(k) is a defined contribution retirement plan which allows the employee to save for retirement in a securities-invested account. The employee's contributions are made with pre-tax dollars and any earnings on those contributions compound tax-free until distribution at retirement. Smaller companies (with fewer than 100 employees) may offer their workers the Savings Incentive Match Plan for Employees, or SIMPLE, plan. This plan operates in the same manner as a regular 401(k), but entails much less paperwork. The SIMPLE does, however, require the company to contribute to their employee's accounts.

The 401(k) contribution process begins with the company's payroll department. The employee instructs the department to withhold a certain amount from his or her pay. Current as well as year-to-date deductions are usually reported on the employee's paystub so that contributions can be followed and kept track of.

The employer, who is the plan sponsor, has a legal obligation to ensure that the 401(k) operates according to the law. In 1997, the U.S. Department of Labor enacted rule changes which mandated that the employer forward all 401(k) contributions to the trustee (or caretaker of the funds; usually a bank, insurance company, or investment firm) to be invested no later than fifteen business days after the end of the month in which those funds were deducted from the employees' paychecks. There are ways to extend this fifteen-day period for up to an additional ten business days, but most companies usually forward 401(k) money to the plan trustee every two to three weeks. Employers must notify their employees if they hold onto their funds for any reason.

The employer must perform a number of administrative activities for each enrolled employee before any contributions can be deposited into the trust. These include ensuring that the right percentage of money was deducted, calculating any matching funds, segregating any necessary monies to be invested according to an employee's wishes, and making sure that there are no IRS attachments which may take precedent.

In most cases, the money is held in a short-term investment fund, or STIF, account. This account, which is usually located at a bank, is used for money that's waiting to be invested -- such as a money market account which pays a short-term rate of interest. If the employer is the owner of the STIF account, then the funds are technically part of the company's general assets and any interest earned stays with the company. However, earnings can be, and generally are, credited to participants' accounts on a "pro-rata" basis.

Once the money reaches the trust, the trustee then invests it according to the employees' directions. The trustee is required by law to protect the funds, invest them according to their given instructions, and be responsible for keeping track of the plan's assets as a whole. If the trustee is also serving as the plan's investment manager, they have the added responsibility of prudently managing and distributing the funds and their earnings to the plan participants or their beneficiaries. Trustees carry liability insurance in case they should break this fiduciary pledge. If the trustee is an individual (for example, an officer of the sponsoring company) then he or she must be bonded, or insured, in case he or she makes a mistake with the money.

The trustee forwards the money to the investment manager, usually within twenty-four hours of receiving it from the company (unless, of course, the trustee is also acting as the investment manager). The money is invested according to the instructions given to the trustee by the plan record keeper. Neither the employer, trustee, nor the investment manager guarantees any set returns on the invested money.

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