Retirement Planning Articles |
Make The Most Of Your 401(k)
As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. That’s because 401(k) plans offer a variety of attractive features that make investing for the future easier and potentially profitable. Be sure to speak to your employer or plan administrator about the specific features and rules of your plan.
What Is A 401(k) Plan?
A 401(k) plan is an employee-funded retirement savings plan. It takes its name from the section of the Internal Revenue Code that created these plans. 401(k) plans are also known as "qualified defined contribution" retirement plans: qualified because they meet the tax law requirements for favorable tax treatment (described below); and defined contribution because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.
The Tax Treatment Of 401(k) Plans
The 401(k) plan allows you to contribute up to $15,500 of your salary in 2008 to a special account set up by your company.* Future contribution limits will be adjusted for inflation. In addition, individuals aged 50 and older who participate in a 401(k) plan can take advantage of "catch-up" contributions, which permit an additional $5,000 salary deferral contribution in 2008 in addition to the $15,500 limit discussed earlier.
Since 2006, 401(k) plans come in two varieties: traditional and new Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.
The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit, However, plan balances grow tax free; you pay no taxes on qualified distributions.
Both traditional and Roth plans require that distributions be qualified. In general this means they must be taken after 59 1/2 (or age 55 if you separate from service from the employer whose plan the distributions are withdrawn), although there are exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.
If your plan permits, you can make contributions in excess of the 2008 limit of $15,500 ($20,500 if over age 50), as long as your total contribution is not more than 100% of your pretax salary, or $46,000, whichever is less. That means if your salary is $100,000, you can contribute up to $46,000 total to your 401(k) plan during that year. In the case of a traditional 401(k), however, only the first $15,500 ($20,500 if over 50) of your contributions can be made pretax in 2008; contributions over and above that amount must be made after tax and do not reduce your salary for tax purposes.
*The maximum salary deferral amount that you can contribute in 2008 to a 401(k) is the lesser of 100% of pay or $15,500. However, some 401(k) plans may limit your contributions to a lesser amount, and in such cases, IRS rules may limit the contribution for highly compensated employees.
Matching Contributions
In addition to its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a Traditional 401(k) plan, is taxable when withdrawn.
Employer contributions may require a "vesting" period before you have full claim to the money and their investment earnings. But keep in mind that if your company matches your contributions, it's like getting extra money on top of your salary.
| Consider the Advantage of Tax Deferral |
 As you evaluate the potential benefits of a 401(k) plan, consider the advantage of tax deferral. This chart shows the result when a hypothetical $100 monthly investment is made for 30 years in a traditional 401(k) plan versus the same investment taxed at 25%, assuming an 8% average rate of return compounded monthly under a plan where earnings are taxed each calendar year. The chart shows that even if the entire amount in the 401(k) plan was withdrawn after 30 years and taxed, there would still be more money left than in the taxable account. Bear in mind that withdrawals from a 401(k) plan before age 59 1/2 may be subject to penalty taxes. This example is for illustrative purposes only and is not indicative of any particular investment or future performance in your retirement plan. |
401(k) Advantages
- Tax-deferred contributions and earnings on traditional plans.
- Tax-free withdrawals for qualified distributions from Roth-style plans.
- Choice among different asset classes and investment vehicles.
- Potential for employer-matching contributions.
- Ability to borrow from your plan under certain circumstances.
Tax-Deferred Compounding Potential: Time Is On Your Side
The benefit of compounding reveals itself in a tax-deferred account such as a 401(k) plan. As the chart on the previous page shows, if your $100 monthly contribution accumulates tax free over 30 years, you could grow your retirement nest egg to $150,030. That’s a difference of almost $50,000 just because you didn’t have to pay current taxes up front!** Of course, you'll have to pay taxes on earnings and deductible contributions to a traditional 401(k) when you withdraw the money. But that may be when you are retired and possibly in a lower tax bracket.
**This example is hypothetical in nature and is not indicative of future performance, nor does it represent a specific product in your retirement plan. Withdrawals prior to age 59 1/2 are subject to a 10% penalty tax.
You’re In Control: Choosing Investments Within Your Plan
Generally, 401(k) plans offer several options in which to invest your contributions. Such options generally include mutual funds that may invest in stocks for growth, bonds for income, or money market investments for protection of principal. This flexibility allows you to minimize investment risk by diversifying your portfolio amongst different types of classes, manager styles, investment styles, and economic sectors.
What To Do When You Change Jobs
Most 401(k) plans permit the employee who terminates employment the options of receiving the 401(k) balance in a lump sum (which is subject to tax) or to receive periodic payments (which are subject to tax) or to roll over the proceeds to an IRA or other employer-sponsored retirement plan. Additionally, some 401(k) plans permit the terminated employee to retain their 401(k) balance in their former employer’s plan. Amounts that are retained in a 401(k) or transferred to another employer’s plan or IRA postpone the taxation until amounts are subsequently distributed from the plan the money was rolled into.
If you choose to receive the funds from your 401(k) with the intention to roll the amount to an IRA:
- You must complete the rollover in 60 days.
- Your employer must withhold 20% of the proceeds as a withholding tax. It is up to you to make up this 20%, or it will be treated as distribution. The money withheld will be used as a credit against your income tax liability.
- Neither the 60-day rule nor the 20% withholding apply to amounts directly transferred to an IRA or other qualified plan.
Borrowing From Your 401(k): Know The Rules
Another potential advantage of some 401(k) plans is that you may be able to borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you. However, borrowing from your 401(k) is generally not recommended since it reduces your investable assets.
There are some other issues to consider. If you leave the company, you may have to pay back the loan in full immediately (subject to the plan’s loan policy). In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.
Work With Your Financial And Tax Professionals
A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult your financial and tax professionals to help you determine how your employer’s 401(k) and other savings and investment plans could help make your financial future more secure.
Points To Remember
- A traditional 401(k) plan allows you to defer current taxes on part of your salary. A Roth 401(k) plan accepts after-tax contributions, but allows for tax-free withdrawals in retirement.
- You can make contributions equal to the lesser of 100% of pay or the 2008 limit of $15,500. Individuals aged 50 and over can make a $5,000 catch-up contribution in 2008 as well.
- One of the biggest advantages of 401(k) plans is that, depending on your plan, employers may match part or all of the contributions you make to the plan.
- 401(k) plans generally provide you with several options in which to invest your contributions.
- In general, if you leave your company and choose to physically receive part or all of your retirement account balance and do not roll it over into another eligible retirement plan within 60 days, you will have to pay income taxes and any penalties.
- Some 401(k)s allow you to borrow as much as 50% of your vested account balance, up to $50,000.
- Distributions can generally be received from your 401(k) as a result of death, disability, retirement, or in some cases, divorce without incurring a 10% penalty for early withdrawals. However, you will still incur ordinary income taxes on the pretax portion of the distribution.
- Loans not repaid to your 401(k) plan within the restricted time period are considered withdrawals and will be taxed and penalized accordingly.
- Borrowing from your 401(k) is generally not recommended and should generally be considered a last resort.
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- I teach at a school that has a 403(b) plan. Is this type of plan a good way to save for retirement?
- Can I roll a retirement plan distribution into an IRA?
- Does the federal government insure pension benefits?
- My company has a profit-sharing plan. How do these plans work?
- What are my options if I inherit an IRA or employer-sponsored plan?
- What is vesting?
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