401(k) retirement plans
A 401(k) is a type of retirement plan that allows employees to save and invest for their own retirement. You decide how much money you want deducted from your paycheck and invested during each pay period, up to the legal maximum. You also decide how to invest that money, choosing from your plan's different investment options. The money you contribute to your 401(k) account is deducted from your pay before income taxes are taken out. This means that by contributing to a 401(k), you can actually lower the amount you pay each pay period in current taxes. For example, if you earn $1,000 each paycheck, and you contribute, say 5% ($50), you are only taxed on $950. You don't owe income taxes on the money until you withdraw it from the plan, when you could be in a lower tax bracket.
The maximum pre-tax contribution for 2007 (and also for 2008) was $15,500 as provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. After 2009, these pre-tax contribution limits will be increased in $500 increments to factor in the effects of inflation. It's important to remember that your employer-sponsored retirement plan(s) may have additional limits.
This law also allows for "catch up" contributions for those age 50 or over. For 2007 and 2008, this contribution limit is an additional $5,000. Beyond 2009, the "catch-up" contribution also will be indexed for inflation.
Some companies offer a "match" or "matching contribution" as an incentive to join the company retirement plan. It means that the company will contribute a certain amount to your account (usually between $0.25 and $1.00) for every dollar that you contribute, up to a certain limit. The match formula can vary. It makes good sense to take advantage of a company match by setting aside the maximum amount required to qualify for a matching contribution. If your employer offers a matching contribution, your savings can grow that much faster.
While many employers make a match to entice their employees to join their company and to contribute to the plan, some require that you work at the firm a certain number of years before the match becomes your property. This is an incentive to keep you on staff, and vesting requirements for employer contributions are common in 401k plans. Plans have two types of vesting schedules: graded and cliff.
- With graded vesting, you own an increasing portion of the employer contribution each year you are with your company. If your company had a five-year graded vesting schedule, you could be 20 percent vested after one year, 40 percent vested after two years, etc. By law, the longest graded vesting schedule a 401k plan can have for employer matching contributions is six years.
- With cliff vesting, the employer contribution goes from zero to 100 percent vested after a set period of time. So if your vesting requirement is three years and you leave your company after two years, you won't get any of the employer contributions. Currently, the longest cliff-vesting schedule allowed by law for employer matching contributions is three years.
Whether or not you can take a loan against your 401(k) plan depends on the provisions of your employer's retirement plan. Not all plans allow for loans. Typically, the maximum that you can brorow from your plan is 50% of the vested amount or $50,000, whichever is less. When you take a loan from your account, you actually take money out of your account, with a promise to repay it. You pay your account back the amount you borrowed plus interest (a fixed rate determined at the time of the loan), through automatic deductions from your pay or bank account, or through coupon payments (as allowed by your plan). The interest you pay your account is not tax-deductible and is paid with after-tax dollars. As long as you repay your loan on time, you won't be subject to withholding taxes or penalties, as you would if you withdraw from your account before retirement.
When you must begin taking your money out
Unless an earlier date is specified by your plan, you must take your first minimum required distribution from your account by April 1 of the year following the year in which you reach age 70 1/2, or April 1 of the year following the year in which you retire, whichever is later.
Generally speaking, you can take your vested account balance with you when you leave your job, although many plans allow you to keep the money in the 401(k) plan. If you decide to change jobs, you generally have three options for your retirement plan savings, listed below.
- Leave your savings in your employer-sponsored retirement savings plan. If you have more than $5,000 invested in your account you may be able to leave your money in the plan if you leave the company. It depends on your company's specific retirement savings plan rules, but many plans allow you to keep your money invested until you retire or turn age 70 1/2.
- Directly roll over all or a portion of your money to another employer-sponsored retirement plan or to a traditional individual retirement account (IRA). (Note you cannot directly roll over monies from a 401(k) plan account to a Roth IRA because of tax implications.) The easiest way to do either of these is to request a "direct rollover," which means that you have your current employer make the withdrawal check payable to your new employer's plan trustee or to your IRA's custodian on your behalf. Perhaps the biggest benefit to having the check made payable to one of these institutions instead of having it made payable to you is the fact that you avoid the mandatory federal income tax withholding. If the check is made payable to you, the federal government requires that 20 percent automatically be withheld up front on the taxable portion of your withdrawal.
- Take a full or partial withdrawal with the check payable to you. Beware of withdrawing money from your retirement savings plan account because you will owe current income taxes on the eligible portion of your withdrawal. In addition, if you take the withdrawal before age 59 1/2, you may also owe an additional 10 percent early withdrawal penalty. If you request that the check be made payable to you, instead of to another employer's qualified plan or to an IRA, 20 percent of your withdrawal will automatically be withheld as prepayment of your federal income taxes. If you have the check made payable to you, and then decide to roll it over into an IRA or another employer's qualified plan, you have 60 days from the date of receiving the distribution check to invest the money. You will have to add the missing 20 percent from other money sources at this time if you want to roll over the entire amount of the withdrawal.
Complete details on these options, and the potential tax liabilities, can be found in the Special Tax Notice Regarding Plan Payments.