Understanding Your 401k
A 401K is a retirement plan sponsored by your employer. It is a defined contribution plan where you contribute a certain portion of your income into the account. 401K accounts are popular because of two main reasons.
As a retirement investment, the 401K has both advantages and disadvantages:
Pros:
- Tax deferred until withdrawal.
- Possibility of additional contributions from employers
Cons:
- Withdrawal penalties of 10% with certain exceptions.
- Lack of liquidity if the contributor needs the money for another purpose.
A further comparison of a 401K plan with other investments can be found here.
Benefits of a 401K
First they are a tax deferred plan, as an example let's say you put $4, 000 dollars into the account over a year and earned $54, 000 that year, only $50, 000 would have to be claimed as income. On the other hand, the benefits upon withdrawal once you've retired are taxed as income. Second, employers may offer a matching contribution giving you a strong incentive to deposit into the 401K account because of the increase in assets gained if employers match the deposit.
The tax deferment option can be advantageous because retirees generally require fewer expenses than during their career so can live off of a smaller yearly income. This drives them to a lower tax bracket so they have to pay less on the withdrawals from their 401K than they would have paid during their working years.
Although a 401K is an employer provided benefit, if you were to change employers and your new employer has a 401K plan, you can transfer your old 401K plan to the new employer. If your new employer does not offer a 401K plan, it can be transferred to an IRA at another institution or the old employer may charge a fee to keep the 401K managed through them.
The money deposited in a 401K is distributed among a variety of assets that could include stocks, bonds, mutual funds, money market funds and others. The options available are based on the specific plan your employer allows and the proportion of funds in each can be regulated by the contributor manually.
Deposit Limits
401K contributions are limited to a maximum of $16, 500 a year in 2009. People age 50 or older are allowed an exception to this limit in the form of "catch-up" contributions. These catch up contributions are limited to $5, 500 in 2009. These limits are also imposed if more than one 401K (such as a traditional and Roth) are owned by the same person, there can be no more than $16, 500 contributed to both accounts combined. These limits are set by the IRS and can differ from the limits set by your employer's plan which may limit it based on a % of yearly income.
Withdrawing Funds from a 401K
The current age requirement to begin withdrawing funds from a 401K is set at 59 . At this point withdrawals can freely be made with no penalty, but an income tax must still be paid. If withdrawals are made before this point, there is a 10% tax added on to the income tax for the withdrawal.
There are a few exceptions to this rule. Some plans may allow the employee to take a loan out from their 401K plan. Loan conditions can vary greatly based on individual plans offered by employers but won't exceed 5 years and will be a reasonable income rate. The income is then paid back and added to the 401K account but does not get the tax deferred treatment that regular deposits get.
In addition to the available loan, 401K plans will not suffer the 10% withdrawal fee if the contributor dies, is disabled or cannot work any longer. If upon leaving the employer which holds the plan, the employee cannot find another plan to transfer the funds to such as an IRA or a new 401K, the funds can be distributed without penalty.
Types of 401K plans
All of the above information was in reference to a traditional 401K plan, the following is a list of non-traditional 401K plans available and how they differ from the traditional plan.
Roth 401K
A Roth 401K differs from a traditional 401K primarily in that it is does not have a tax-deferred contribution. This means that an income tax is paid on all income before the contribution is made but at the time of withdrawal, no income tax is paid. There are additional restrictions associated with a Roth 401K. The $16, 500 limit is imposed on a combination of traditional and Roth 401K that an employee may have so they cannot invest $16, 500 in two separate accounts.
SIMPLE 401K
This is a type of 401K plan available to companies with 100 or fewer employees. The employees eligible must have received at least $5, 000 in pay from the company in the last year. Traditional 401K plans have a requirement for the employer to test whether the higher compensated employees in the company are being treated as equally as lower paid employees. The SIMPLE 401K eliminates those testing requirements so allows small businesses to provide retirement benefits to their employees without high costs. One difference is that the SIMPLE 401K has a lower limit of $11, 500 contribution per year in contrast to the $16, 400 limit in a traditional 401K.
401K plans are popular among employees and are the major source of retirement income for 44% of all workers. It is important when planning for retirement to understand the different options available and fitting them to your personal preferences. You can read more about how a 401K fits into saving for retirement and retirement investing
The original article can be found here:
Understanding Your 401k
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