What is 401(k) retirement savings plan ?401(k) is a retirement savings plan for a working individual in United States of America. 401(k) plans are sponsored by your employer. In this post you will find out a quick overview of the rules and regulations and the most important things you need to know about 401(k) investments.
401(k) investment options Money contributed to 401(k) plans is invested in various mutual funds investing in Stocks, Bonds or Money market investments. There are two types of 401(k) plans based on who has control on how the money is invested.
- Participant-directed 401k plans - These are plans in which as an employee you can choose how much portion of your money is invested in which particular financial instrument. Most 401k plans are of this type.
- Trustee-directed 401k plans- choice of investment options is made by the employer.
401(k) tax exemption rulesIt is important to understand the tax consequences of your 401(k) contributions. The key points to remember are:
- Investments in 401(k) plans are tax deferred. i.e. you do not pay income tax on your 401(k) contributions (at the time of the contribution), but you pay tax at the time of withdrawal.
- The returns on your 401(k) are tax-exempt : You earn from your 401(k) investments in the form of interest or dividend or capital gains. The biggest advantage of 401(k) retirement plans is that these earnings are not taxable.
401(k) rules for early withdrawals
- Pay income tax on 401(k) withdrawals: As explained above in 401(k) tax rules, you have to pay tax on the 401(k) withdrawal amount when you withdraw money.
- 401(k) hardship withdrawals: Many employers allow 401(k) withdrawals only if there is a financial hardship, e.g. 1) pay medical expenses, 2) pay college tuition fees, 3) for payment or installments etc. in order to avoid eviction or foreclosure of primary residence 4) for funeral of a family member. What exactly qualifies as financial hardship for the case of 401(k) withdrawals is decided by your employer usually based on predetermined criterion.
- 10% Excise tax for premature 401(k) withdrawals: Withdrawals from your 401(k) account before you turn 59.5 years old and (while you are still in service of the company) involves a penalty in the form of 10% excise tax on the withdrawal amount. Note that this excise tax is in addition to the income tax you pay on the invested amount. However you do not have to pay this 10% excise tax in the case when you are leaving your company after you are 55 years old or if you become disabled.
401(k) rules for loansAlthough direct withdrawals from 401(k) involve a penalty, several (but not all) 401(k) plans allow you to take a loan on your 401(k) contributions at a predetermined interest rates. The 401(k) rules for taking loan (if it is allowed) are as follows.
- The amount of loan you can avail is the minimum of 50% of your 401(k) balance or $50,000.
- The 401(k) loan has to be repaid in 5 years, unless it is meant for purchase of a primary residence.
- In case you take a 401(k) loan and decide to quit your job, you may have to pay back the outstanding loan balance in full. Otherwise the outstanding balance may be treated as a premature 401(k) withdrawal and maybe subject to 10% excise tax as mention above.
401(k) maximum limit rules and regulations There is a maximum limit on the amount you can invest in all 401(k) plans in a given year and it is the minimum of the following two:
- The maximum percentage of contribution limit set by your employer.
- The maximum 401(k) limit as prescribed by the federal government. The 2010 401(k) maximum contribution limit is $16,500 for employees below the age of 50 years and $5,500 for employees over the age of 50.
401(k) Rollover rules and optionsYou have the following options to deal with 401k contributions in case you retire, quit or change your job and do not want to leave your 401(k) assets with your former employer.
- 401(k) Rollover Option 1: You can choose to rollover your entire 401(k) contribution to an IRA account, which you will have to setup before the rollover.
- 401(k) Rollover Option 2: You may be able to make a rollover of your 401(k) assets to a retirement savings plan offered by your new employer (which could be another 401(k)).
- 401(k) Rollover Option 3: You can choose to receive all your 401(k) assets, without making a rollover. However, remember that you will have to pay income tax according to 401(k) tax rules mentioned above. Moreover it is mandatory for your employer to withhold 20% on the amount of your 401(k) withdrawal for Federal Income tax. You are supposed to pay the remaining tax (after this 20% withholding) when you file your income tax return. In addition to the income tax, you also have to pay 10% excise tax if your age is below 59.5 years (as mentioned in 401(k) early withdrawal rules).
401(k)- additional benefits like matched contributionsSeveral employers, as part of their pay-package, match the contributions in 401(k) account. I.e. if you invest $1000, your employer will invest an additional $1000 on your behalf, thus doubling your investment. It is worth finding out if indeed your employer matches you 401(k) contribution by directly asking your employer.
External useful links related to 401(k) contributions
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