The 1974 Employee Retirement Income Security Act requires companies to keep funds in qualified retirement plans separate from other company accounts. In 1978 Congress passed the Revenue Act which included a provision to amend the Internal Revenue Service tax code. The change allowed employers to pay a portion of an employee's salary as deferred compensation 401k plans. In 1981 the IRS began to classify the deferred contribution plans as retirement accounts which brought them under the protection of ERISA.
401k accounts are tax-deferred retirement accounts. The IRS assess a 10 percent penalty on withdrawals made before age 59 1/2. Since 401k funds are not taxed at the time of contribution, the IRS compels people to begin required minimum distributions from 401k plans no later than age 70 1/2. Some companies require employees to work for one year or more before making matching contributions to the plans, and funds are not vested until at least three years after the employee's start date.
401k plans allow employees to direct their own retirement plan by selecting accounts in which to invest funds. 401k plans employ a dollar-cost-averaging technique to protect participants from market turbulence by investing small increments on each payday rather than one big investment a year. Most 401k plans contain conservative, moderate and aggressive mutual funds that cater to people of different ages and with different levels of risk tolerance. Plans also include cash accounts for very conservative investors.
When a company closes, most 401k plan participants have the funds rolled over into an IRA mutual fund, IRA CD or annuity. The IRA rollover does not expose the funds to taxation if done within 60 days, and investors may even invest in the same underlying mutual funds that the plan previously held. If the 401k administrator mails a distribution check to the employee, the IRS requires a 20 percent tax withholding that can be refunded at the end of the tax year. Direct transfers to the IRA custodian avoid that issue.
Plan participants do not have to roll over 401k funds when a company closes unless the plan administrator decides to terminate the plan. Many plans of bankrupt companies continue to operate while creditors battle over other assets. In situations when the plan does not immediately end, an individual who finds new employment can transfer the money directly to the 401k plan at a new company. This process eliminates some of the fees involved in using a broker to open a self-directed IRA.