By William H. Black Jr.
There’s a time in a self-storage operator’s life when the question arises, “How do I keep more of the money I make?” Frequently, the answer is “with a qualified plan.” Called “qualified” because the contributions qualify for an income-tax deduction, these plans offer many significant benefits.
While there are many types of qualified plans available, this article focuses on the most popular, the 401(k) plan. Of course, implementation is strictly your decision; but before you make it, let’s discuss the basics.
What Is a 401(k) Plan?
In essence, a 401(k) is a tax-deductible savings account. Its name is taken from the Internal Revenue Code. These plans first became popular in the 1980s and are rapidly becoming an alternative to the more traditional retirement pension previously sponsored by employers, otherwise known as defined-benefit plans. However, the 401(k) structure does place the bulk of the responsibility of saving and investing on the employee himself. Additionally, employer contributions can vary drastically in amount and frequency.
Saving with a 401(k) retirement plan helps reduce taxable income, as all contributions by the employee and employer are deductible. And under the Employee Retirement Income Security Act of 1974, pension monies are judgment-creditor proof!
These plans generally offer various options as to how and where contributions are invested. Typical investment options are mutual funds, money-market investments, Target Date Funds, Asset Allocation funds or a combination thereof. Most plans offer the employee flexibility in how to allocate his account balance among the offered investment options. A good platform offers each participant his own private Web page to access his account and make trades.
What Is a Matching Contribution?
A matching contribution is an extra contribution to your account, paid for by the company, with tax-deductible dollars. Many plan designs will match whatever contribution you make, up to a certain percentage.
For instance, let's say in your design the match is 100 percent of your contribution up to 3 percent of your W-2 income. Assume you make $50,000 a year and you contribute 3 percent, or $1,500. Your company will match that at 100 percent, putting another $1,500 in your account. So in this particular year, investment gains aside, your 401(k) savings would go from $1,500 to $3,000—an exceptional increase in your account by any measure!
What Is Vesting?
Simply put, vesting is “earning” the employer’s contributions. 401(k) plans are not bonus plans. They are not severance-pay plans. They are rewards for long and loyal service. Employees who leave early abandon all or part of the employer’s contribution. For example, let's say your company requires six years of employment before being fully vested. If an employee leaves before that time, he won't be able to keep all the money his company contributed.
Of course, all the money employees contribute and any Safe Harbor employer contributions vest 100 percent immediately. A Safe Harbor 401(k) is similar to a traditional 401(k) plan, but the employer is required to make contributions for each employee. One other point: Vesting accelerates to 100 percent on a participant’s death, reaching retirement age or plan termination. That’s the exception.
If an employee leaves employment after, say, two years, he’ll likely keep only 20 percent of the company's contributions. The other 80 percent is forfeited, stays in the plan and is allocated, or spread, among the remaining participants.
What Happens When an Employee Leaves?
If an employee leaves or is terminated, any monies he deferred from salary, any Safe Harbor contributions and any vested employer contributions are payable to the employee. All other monies are forfeited. How does a former participant receive his vested account? He can roll it over income-tax-free to his IRA account, roll it tax-free to another employer-sponsored plan (if allowed by the plan document), or take the money, pay tax on it, and do whatever he chooses.
How Are Income Taxes Paid?
You don't have to pay tax on the money you contribute from your salary or any funds your company adds in the year contributed. You also don’t pay taxes on the earnings in your account or the forfeitures allocated to your account. In other words, as long as the money remains in the account, it grows without current taxation and is protected from the claim of judgment creditors. For example, if your income is $150,000 this year and you put $17,500 into your 401(k) account during the year, your taxable income next April 15 will be $132,500 ($150,000 minus $17,500), not $150,000.