401(k) and your retirement

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:
  1. funeral expenses
  2. medical expenses
  3. college tuition
  4. mortgage or rental payments
  5. 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.

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