Have you ever wondered what those numbers and letters mean when people talk about a 401(k) and a 529? Have you ever wondered why they are important? In this newsletter, you’ll find out. Although the answer to the first question is simple, you are rarely told what it is. Both the 401(k) and the 529 are named for the section number of an amendment that was made to the Internal Revenue Code. An amendment is made to the Internal Revenue Code when Congress decides changes are needed.
The 401(k) Savings Plan—Saving for Retirement
The 401(k) Savings Plan is a plan that allows you to save for retirement. It is a long-term savings plan instituted by an employer in which a deposit is deducted automatically from your paycheck and invested by a plan manager. This deduction is most often expressed as a percentage of the total amount of pay. For example, if you receive $1,000 per month in wages and you choose to have 2% of your wages deposited into a 401(k) retirement account, $20 of your paycheck would go to the 401(k) and you would only pay taxes on the remaining $980. In 1978, Congress amended the Internal Revenue Code and added section 401(k). The important distinction this section made was that employees will not be taxed on income they choose to defer (deposit) to plans they will withdraw from at retirement until the withdrawal is made. The law went into effect on January 1, 1980, and by 1983 almost half of the biggest companies in the U.S. were either offering a 401(k) plan or had plans to do so.
Originally intended for executives, the section 401(k) plan became popular with workers at all levels because 1) It allowed higher yearly contribution limits than the already existing Individual Retirement Account (IRA); 2) employers frequently deposited matching funds in the employees’ accounts; 3) 401(k) plans often allowed loans; and 4) employer’s stock was sometimes an investment choice.
By 1984, thousands of U.S. companies were offering 401(k) plans, and Congress passed additional legislation to ensure that the plans did not discriminate in favor of highly paid employees. They did this by putting a limit on the amount of pay that could be deferred. The Tax Reform Act of 1986 tightened the nondiscrimination rules even further and reduced the maximum annual 401(k) before-tax salary deferrals by employees.
In 1998, Congress passed legislation that allowed employers to put automatic deductions in place to have all employees contribute a certain amount into a 401(k) plan unless the employee actively chooses not to contribute.
One big reason for the instant popularity of 401(k) plans with employers was that these plans are less expensive for employers to maintain than the previous pension plans for every retired worker. With a 401(k) plan, the employer only has to pay the costs of administering the plan. Matching contributions by the employer are optional, meaning that employers can choose whether or not to include matching contributions in their plans. The federal regulations do not require that matching contributions be included. Employers can also choose to contribute some years and not others. For example, in years with strong profits, employers can make matching or profit-sharing contributions, and reduce or eliminate them in poor years. Also, 401(k) plan costs are much more predictable for employers, whereas the cost of previous pension plans could vary unpredictably from year to year.
The 529 Savings Plan—Saving for College
The 529 Savings Plan is named for section 529 of the Internal Revenue Code which was added in 1996 as part of the Small Business Job Protection Act. With the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 529 Savings Plans gained their current prominence and tax advantages. The 529 Savings Plan is a plan that is intended as a way to save for future college education expenses for your children, grandchildren, or other person that you designate as a beneficiary.
The advantage of a 529 Savings Plan is that, although deposits you make are not pre-tax contributions, when the withdrawals are made for qualified higher education expenses, they are exempt from federal income tax so your designated beneficiary will not be required to pay taxes on them. There can also be matching grant and scholarship opportunities, protection from creditors for the money deposited in the plan, and often the deposited funds don’t have to be included in state financial aid calculations for people who invest in 529 plans within their state of residence.
There are two types of 529 plans: Prepaid Plans and Savings Plans. Prepaid Plans are administered by states and by higher education institutions. If you choose to invest in a Prepaid Plan, the money you deposit “buys” tuition credits at the price of tuition when you deposit the money. Therefore, if the cost of tuition increases before your beneficiary is ready to withdraw the money, you do not have to pay that increase and thus, your deposit has earned the difference between the cost of tuition you paid and the cost of tuition at the time of withdrawal.
These plans are available in all 50 States through financial institutions or higher education institutions. They are not available through employers. You will need to check with your financial institution or through the school you are interested in to see what is available. The nice thing about these plans is that there are no age or income restrictions, and although the plans are offered by individual states, there is no residency restriction, which means that if you live in one state, you are allowed to participate in a plan for a school in another state.