Find out how a 401(k) retirement plan really works.
You’ve probably heard of a 401(k)—it’s the most popular type of retirement plan and one of the best benefits that a company can offer its workers. But I’m sure you won’t be surprised to hear that a 401(k) comes with lots of rules and regulations.
What Should You Know About Your 401(k)
Being familiar with how a 401(k) really works is the best way to make sure you understand all your options for your retirement money and to stay clear of transactions that could trigger unnecessary taxes and expensive penalties.
What is a 401(k) Retirement Plan?
A 401(k), and its sister for non-profit organizations called a 403(b), is a retirement plan that you can participate in through your employer. I’ll just be referring to 401(k)s in this article, but the same rules generally apply to 403(b)s. These plans allow you to elect to have your employer contribute a portion of your paycheck to the account.
When you sign up for a 401(k), you receive a menu of investment options to choose from, some of which might be a family of funds like Vanguard, Fidelity, or American Funds. You’re responsible for picking investments that are most suited for your risk tolerance and retirement objectives.
10 Rules About 401(k) Plans You Should Know
Here are 10 important rules about 401(k) retirement plans that you should know:
401(k) Rule #1: Contributions Must Come From Payroll Deductions.
If you’re used to making contributions—to an IRA or to a brokerage account like Betterment—from your checking or savings account, it may seem a little strange that you can’t contribute to a 401(k) the same way. The only way you can move money into a 401(k) is through direct payroll deductions, which are called elective deferrals.
I’m sure you’d agree that this payment arrangement is a clever way to make it easier for you to automatically save for retirement. When money’s out of sight, it’s certainly out of mind. You won’t even miss those retirement contributions after a while!
401(k) Rule #2: There’s an Annual Limit on How Much You Can Contribute.
For 2014, the maximum amount you can put in a 401(k) is $17,500. But if you’re age 50 or older, you qualify for additional “catch up” contributions and can sock away up to $23,000. Even if you have a second job or are self-employed (and also have a SEP-IRA, for instance), your total contributions to all workplace plans cannot exceed 17,500 or $23,000 for 2014.
401(k) Rule #3: Employers Can Match Your Contributions.
Besides the fact that 401(k) contributions are automatic, another smart reason to participate in one is that some employers will match what you put in. A typical match might be something like 50% of the first 6% of your salary that you contribute. Here’s how that breaks down: If you make $50,000 a year and contribute 6% of that amount, or $3,000, of your own money, your company would kick in 50% or an additional $1,500. It’s like getting a raise without having to do any extra work!
And the great thing about matching funds is that they don’t count toward the annual limits I mentioned. The total for both employee and employer contributions can be as much as 100% of your pay up to $52,000 for 2014.
401(k) Rule #4: Contributions to a Traditional 401(k) are Tax-deductible.
Regular or traditional 401(k)s allow you to contribute money on a pretax basis. You don’t pay a penny of income tax on the amounts you contribute, nor do you pay tax on any investment gains in the account—until you take withdrawals from the plan. However, your contributions are still subject to other taxes including Social Security, Medicare, and federal unemployment.
401(k) Rule #5: Contributions to a Roth 401(k) are not Tax-deductible.
Many employers are adding a Roth feature to their 401(k) plans that allows you to make contributions on an after-tax basis, just like with a Roth IRA. Roth contributions don’t give you an upfront tax benefit; however, distributions are completely tax-free. If your Roth mushrooms in value, you could save a small fortune by not having to pay tax on decades of account growth.
To find out whether a traditional or a Roth retirement plan is right for you, read my previous article What’s the Difference Between a Traditional and Roth 401(k)?.
401(k) Rule #6: You Can Also Contribute to an IRA.
This rule trips up lot of people because they don’t realize that your participation in a 401(k) has no impact on your ability to contribute to an IRA. You can max out both a retirement plan at work and an IRA in the same year. But depending on your income, your ability to deduct contributions to a traditional IRA may be limited if you or your spouse also participate in a retirement plan at work.
401(k) Rule #7: When You Leave You Can Take Your 401(k) Funds with You.
The contributions that you make to a 401(k) are always 100% vested, which means that you own them. It doesn’t matter whether you tell the boss to take their job and shove it or whether they escort you out the front door—your retirement money is safe. However, the money your employer kicks in may be subject to a vesting schedule that could require a number of years of service before you fully own those funds.
You can roll over the money from your old 401(k) into a new employer’s plan or into an IRA without having to pay any taxes or penalties. For more details read my previous article, How to Handle Retirement Rollovers Correctly.
401(k) Rule #8: Early or Late Withdrawals are Penalized.
A very important point to understand about a 401(k) is that it’s not like a savings account where you can just withdraw money at any time. The IRS prohibits you from withdrawing funds from a retirement account before age 59½, except in extreme cases—and even then you may still have to pay a 10% early withdrawal penalty.
Once you reach age 70½ or retire from your company at an older age, you must start taking required minimum distributions or RMDs from your traditional 401(k) each year, or face steep penalties. Just like with Roth IRAs, there are no RMDs for Roth 401(k)s since you already paid taxes on your contributions.
401(k) Rule #9: You May Qualify for a Hardship Distribution.
Many, but not all, plans allow you to make hardship withdrawals for certain immediate financial needs such as preventing foreclosure or paying for medical bills, a funeral, or college. If you qualify for a hardship distribution, it’s still considered an early withdrawal that’s subject to the 10% penalty I mentioned. I covered the topic of taking 401(k) withdrawals in Should You Take a 401(k) or 403(b) Withdrawal?, so I’ll refer you to that post for more information.
401(k) Rule #10: You May Be Eligible to Borrow from Your 401(k).
Some plans allow you to take an interest-bearing loan from your 401(k) for up to one half of your vested account balance up to $50,000. Since I also covered this topic in a previous article, Should You Take a 401(k) Loan?, you can read it for more details.
Workplace retirement plans can be complicated because employers have some flexibility in how they design them. But I promise that they’re worth taking the time to figure out because they offer such great savings and tax benefits. The best way to understand specific rules that apply to your situation is to read your 401(k)’s Summary Plan Description document or ask your plan’s administrator for more information.
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