The 401(k) is a retirement savings plan that happens through the employer. Here are some major points about the 401(k) plan:
- Contributions made to the account are pre-tax. Depending on a person’s tax bracket, this can mean substantial savings when investing money for retirement.
- The employer automatically takes out the money from the employee’s paycheck. An employee can typically start and stop investing into a 401(k) on a monthly basis.
- The employer picks a financial investment company to manage the 401(k) for them. Money is invested in mutual funds of stocks and bonds. Investment choices may be limited but are self directed.
- 401(k)s are not guaranteed savings plans.
- Earnings grow tax-free.
- Withdrawals are subject to taxation. Early withdrawal is subject to an additional fee.
Company matching is an employee benefit where the company agrees to match a percentage of the employee’s contributions. Here are some points about company matching:
- Company matching is usually limited to a set percentage. Typically, it is worded like “the company will match 50% up to the first six percent†of what you contribute. Employers cannot contribute more than six percent of your salary to a 401(k).
- You can only keep company matched savings if you are properly vested with the company. This means you have to stay with the company for a set number of years. If you leave before that time is up, the amount of company matching you get to keep in your 401(k) may be limited by your vesting.
- Vesting normally takes three to five years. Graded vesting means your vesting is increased each year. You are vested 20% after one year, 40% after two years, etc. Cliff vesting means you are not vested at all until after the vesting schedule. For example, with a three-year vestment period, you are 0% vested after one year and two years. After three years, you are 100% vested.
Maximum amounts limit how much a person can contribute to a 401(k) account. Here are details regarding contribution limits:
- Starting in 2009, the maximum annual contribution made to a 401(k) account is $16,500.
- This amount increases after age 50 ½ to $22,000.
- The contribution limit includes the total contribution between employee and company.
- Highly compensated employees face further restrictions over what they or their employer can contribute to his or her 401(k) account.
Variations of 401ks include:
- 403(b) is for the non-profit sector. Hospitals, churches, charities, and college employees use a 403(b) instead of the 401(k) savings plan
- Starting in 2006, employees can opt for the Roth 401(k) if the employer avails this option. In this case, money is contributed after being taxed but it is distributed tax-free.
- The Solo 401 (k) plan is just like the 401(k) plan but for self-employed people who do not have employees except for spouses.
The following points specify 401(k) withdrawal:
- If you take your money out before you turn 59 ½, you must pay the IRS a tax penalty of 10% of the total money withdrawn.
- You can roll over the money from a 401(k) into an IRA without tax penalty.
- You can take money out if you show justifiable hardships. Reasons the IRS will accept for a hardship withdrawal include:
- funeral expenses
- medical expenses
- college tuition
- mortgage or rental payments
- to purchase or repair your main home
- Tax law under 72(t)(2)(A)(iv) is a little known rule that lets you start your withdrawals earlier than when you turn 59 ½ without suffering an early withdrawal tax penalty.
