How Does Your 401(k) Really Work?

So you participate in your company’s 401(k) plan — way to go! You’ve made a great choice in planning for your future. You’re putting pre-tax dollars into a tax-deferred investment vehicle so functionally, you may think it’s similar to investing in an individual retirement account (IRA).

But structurally, a 401(k) is very different from an IRA. Understanding the technical details of your 401(k) is not crucial to utilizing it effectively, but as they say, “knowledge is power”!

Let’s take a few minutes to explore how it works.


What’s Under the Hood?

To understand the legal structure of your 401(k), it is important to understand the concept of a trust. A trust is an arrangement between three parties that unambiguously dictates how property should be transferred through written instructions. The grantor (or trustor) is the original owner of the property, and the beneficiary is the recipient of the property. The third party, known as the trustee, is an intermediary who oversees the transfer of the property from the grantor to the beneficiary. The trustee must serve as a fiduciary to the beneficiary, meaning they are held legally liable if they don’t act in the beneficiary’s best interest. These three parties may not all be distinct persons; for example, the grantor may also serve as the trustee.

Now, if the property that is being transferred through the trust is cash or some other form of money, then the trustee may choose to invest the cash as part of their fiduciary duty. This means the money will be put into an account that is legally associated with the trust, in accordance with the trust’s written instructions. Under these circumstances, the account is called a trust account. When you hear someone say, “money in the trust,” this is just common parlance for, “money in the trust account”.

Still with me? Now that we’ve covered the prerequisites, we can bring retirement plans into the picture.

Meet the Key Players

While there are several different types of retirement plans, certain roles are universal.
The plan sponsor is a party — usually a company or an employer — that establishes the retirement plan for the benefit of another party (typically the employees of a company). The second party is commonly referred to as the plan participants. Retirement plans are generally set up within a trust structure between the plan sponsor and the plan participants.

Depending on the plan type and specifics, money (property) may be transferred from the plan sponsor, like a grantor, to the plan participant, like a beneficiary. For this very reason, retirement plans use trust documents to clearly identify each party and trust accounts to hold the plan assets.

The plan sponsor may serve as the trustee or opt to elect a third party to serve as the trustee. In the latter case, the trustee can either be a directed trustee, where they are responsible for doing what the plan sponsor instructs them to do, or a discretionary trustee, where they have discretion over the assets in the trust account. The trustee “owns” the trust itself and is responsible for both monitoring and managing the assets in the trust account, in accordance with laws under the Employee Retirement Income Security Act of 1974 (ERISA).

Beyond the three trust parties listed above, there are other important players working behind the scenes of your retirement plan, such as plan administrators, third-party administrators (TPAs), recordkeepers and registered investment advisors (RIAs) or consultants:

Plan Administrators: Similar to trustees, plan administrators must serve as fiduciaries on behalf of the plan participants, but their responsibilities lie outside the management of the trust’s assets (which is the trustee’s job).

TPA: The TPA is a non-fiduciary and serves as an assistant to the administrator; however, in some cases, both TPA and administrative responsibilities may be handled by the same entity.

Recordkeeper: Recordkeepers manage bookkeeping duties and day-to-day operations for the plan, from investment selections to participant contributions.

RIA: An RIA serves as a fiduciary to the plan and to the plan participants, and recommends investment options in which the plan participants can elect to invest their share of the trust account. Retirement plans may hire brokers instead of RIAs, who follow a suitability standard instead of a fiduciary standard. (Click here to learn more.)

Almost There…

Retirement plans for private employers often come in two flavors: defined benefit (DB) plans and defined contribution (DC) plans. In DB plans, the plan sponsor arranges to put funds into the trust account for the plan participants, who can later claim their share at retirement. In DC plans, plan participants elect to deposit funds into the trust account, and in return, they each receive a fractional ownership share of the overall property within the trust. It’s important to note the distinction between the trustee, who owns the trust itself, and the plan participants, who own shares of the property within the trust account. A 401(k) plan is a special type of DC plan that complies with IRS code 401(k), which mandates the basic details about how the plan must be structured.

Now let’s put it all together: When you say that you “participate in a 401(k)”, what you really mean is you “are the beneficiary of a fractional ownership share in the property that is governed by a trust — and held in a trust account — whose instructions describe a DC plan that is compliant with IRS code 401(k).”

That’s quite a mouthful!

In contrast to the plans described above, an IRA is simply an account that has a special tax status endowed upon it. Ownership over the funds contained within an IRA is very straightforward — you own everything in the account, rather than owning only a fractional share of it. However, this simpler structure has its shortcomings: there is no fiduciary automatically assigned to keep your best interest in mind. If this is important to you, then you should seek assistance from an external fiduciary, such as an RIA, if you decide to open an IRA.

There are a lot of moving parts and dedicated teams of people who are working to help make sure your funds are working for you — even when it feels like your money is sitting in a simple retirement account. Hopefully, you can better appreciate the intricacies behind the scenes of your retirement plan the next time you make a contribution.


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How Does Your 401(k) Really Work?

time to read: 4 min