Today, it's critical for Americans to take their retirement funding into their own hands. This is primarily done through the use of 401k retirement plans, which are designed to help individuals pay for expenses after they retire. These plans offer a vast array of potential features that can make investing money for the future more profitable and easier.
Following are all of the key points you should know about having a 401k retirement plan. Discuss the specifics of your plan with your employer or the plan administrator.
A 401k is classified as a savings plan for retirement, typically funded by the employee. The name is derived from the Internal Revenue Code that addresses these plans. A 401k is also called a qualified defined contribution plan. Qualified refers to the fact they meet the required tax codes and defined contribution because they are defined by the terms of the plan. This will vary based on investment returns and plan balances.
A 401k allows for contributions up to $18,000 from your salary each year. This amount will be adjusted at future dates to accommodate inflation. However, individual plans may have lower allowable amounts. Individuals who are 50 years old or older may make an additional $5,500 in catch-up contributions.
There are two types of 401k plans available: Roth and traditional. A traditional 401k retirement plan defers the payment of taxes on your contributions until the time at which those funds are withdrawn during your retirement years. Upon withdrawal, these funds will be taxed as if they were a typical income. Because these contributions are taken out of your paycheck prior to taxes are taken out, it reduces your taxable income.
Roth 401k retirement plans work differently. With this type of plan, you will make contributions after taxes are removed, which means there is no tax benefit immediately. However, this also means the balance will grow with no taxes paid, even upon distribution, as long as these withdrawals take place under the proper guidelines. Both types of retirement plans require distributions be taken at age 59 ½ or older or 55 years old if you are leaving your employer. There are exceptions for hardship withdrawals based on IRS definitions. If individuals take a distribution that falls outside those guidelines, the IRS will implement a penalty of 10 percent in addition to typical income taxes.
When permitted, you may be able to make contributions beyond $18,000 (or $24,000 for individuals over age 50), as long as any money added doesn't exceed 100 percent of an individual's pretax salary or $45,000, whichever amount is less. For instance, if your salary is $100,000 per year, the total allowed contributions is $45,000 during a year. With a traditional 401k, only the first $18,000 or $24,000 for individuals over 50 will be deducted pretax. Anything beyond that amount will be taxed prior to its removal from your salary.
In addition to the pretax deductions, many people choose a 401k retirement plan because their employer matches some of their contributions. In most situations, an employer will match only a portion of the contribution. For instance, they may contribute half of the first six percent you contribute. With a Roth 401k, any matching contributions are kept in a separate tax-deferred account, which is similar to a traditional 401k and will be taxed upon withdrawal.
Any contributions provided by the employer may require you to work for a period of time in order to become vested, which means being able to claim the money and any investment earnings. However, if your company does match contributions, this is considered money beyond your salary.
As you think about whether you want to invest in a 401k plan, it's important to think about the benefits of tax deferral. Consider the difference of investing in a 401k plan versus a different investment account that is fully taxable. If you put $100 a month into each of these accounts over 30 years, the results will be different. For this exercise, consider an eight percent rate of return that is compounded monthly and a tax rate of 25 percent. All interest income is taxed at the end of the calendar year.
If you were to withdraw the entire amount in the 401k plan at the end of the 30 years and paid the taxes, you would still have more money than you would have in the taxable account. It's important to remember any money taken from the 401k prior to age 59 is typically subject to penalties and taxes. This is a hypothetical situation and may not accurately reflect exact performance.
The benefits of compounding quickly become evident when looking at a 401k retirement plan that offers tax advantages. For instance, that $100 per month for 30 years will accumulate without being taxed, helping you quickly grow a retirement account to about $150,030. This is approximately $50,000 more due to not paying taxes upfront. While you will have to pay taxes on the earnings, as well as deductible contributions when the money is withdrawn, it's likely you will fall into a much lower tax bracket when retired.
You will typically have several options for your investments when opening a 401k. Some of these options may include bonds for income, money market accounts to protect principal and stocks for growth. You will have the flexibility to divide your contributions among these different investments to create a portfolio that is more likely to produce the money you need for your retirement. The appropriate disbursement of funds depends on how aggressive the account needs to be. The closer to retirement you are, the more conservative your investments should be.
If you retire or change jobs, there are four options for your retirement account. You can maintain your account with your previous employer if it is allowed. You may be able to transfer the funds to a retirement account with your new employer. Another option is to rollover the balance into an IRA account at your bank. Finally, you can take the cash. In most cases, the first three options are preferred because they come with no tax consequences. However, if you choose the cash disbursement, you will be penalized a 20 percent withholding, a 10 percent penalty tax and your typical income tax on the contributions and the earnings.
As you consider the first three options, think about the availability of the investment options and how easy it will be to access the funds when needed. Rolling your funds into an IRA at your own bank can offer the most control and flexibility, giving you a vast array of investment options.
This refers to the length of time you have worked for the employer in charge of the plan.
Termination means you are no longer employed by the company.
With a 401k, you are often able to borrow up to half of your vested account balance up to an amount of $50,000. If you are able to pay the loan back, including interest, within five years of taking out the loan, you will not be assessed any penalties.
Unfortunately, if you leave your current employer prior to paying back the loan, you may be required to repay the balance, depending on the rules relating to your plan. If the loan is not repaid in time, it may be assessed taxes and penalties similar to those charged to an early withdrawal.
To further protect your funds, 401k service providers often cover these accounts with a fidelity bond. This bond is a type of insurance designed to protect retirement funds from loss due to dishonest or fraudulent acts by those who are covered under the bond.
A 401k is a great foundation for your personal retirement savings and the key to your financial security in the future. It's important to talk to a financial adviser or your plan administrator to help ensure your employer's 401k retirement plan is working for you.