|
401(k)s are company-sponsored retirement plans that allow employees to set
aside and invest a portion of their income before taxes. 401(k)s get their
names from the section in the U.S. Tax Code that addresses the product.
Tax Treatment
Contributions into a 401k plan are made on a pre-tax basis. This means you do
not pay federal income tax on the money deferred to the plan. This is a great
way to save for retirement without significantly affecting your take-home pay.
Plus, since contributions are pre-taxed, your current taxable income for the
year is reduced.
Your contributions are also able to grow tax free while in your account. This
is one of the major benefits of the 401k plan.
However, when the time comes to take money out of a 401(k), you must pay taxes
on both the principal and the gains.
Contribution Limits
As of 2007, the maximum annual pre-tax contribution to a 401(k) plan is
$15,500. This amount is adjusted for cost of living increases, which are
applied in $500 increments.
If for any reason you contribute more than their maximum pre-tax limit, you
must withdraw the excess amount by April 15 of the following year. If you do
not make this correction in time, the excess amount is considered
“non-qualified” and may be subject to taxation and penalties. 401(k) plans can
also accept employer contributions. Companies make contributions to these plans
as an incentive to get employees interested in saving for retirement. An
employer’s match is subject to vesting, which means you may need to satisfy
specific employment requirements before taking ownership of these funds.
The IRS has also imposed a total contribution—employee and employer—limit. The
maximum amount is the lesser of 100 percent of compensation or $45,000.
Catch-Up Contribution Limits
Catch-up contributions were created as an option for those who haven’t saved
enough for retirement. If you are over the age of 50, you can make catch up
contributions as retirement draws near. The maximum contribution amount is
$5000. For future years these limits may adjust in $500 increments to account
for inflation.
Income Limits
There are no income limitations for participating in a 401(k).
Contribution Deadlines
Employer contributions must be made by the company’s tax-filing deadline.
Investment Choices
There is a wide array of investment choices to take advantage of depending on
your plan provider, such as mutual funds, guaranteed interest vehicles,
equities, bonds, and so on.
Early Withdrawal
Early withdrawals taken prior to the required age of 59 ½ are subject to
taxation and an early-withdrawal penalty of 10 percent. The IRS allows early
distributions for “hardships” that fall into these categories.
-
Purchase of a primary residence
-
To avoid foreclosure or eviction of a primary residence
-
Medical expenses not covered by employees insurance
-
Funeral expenses for parents, spouse, or dependants
-
Payment of secondary education expenses
-
Home repairs due to a deductible casualty loss
Another common form of early distribution from a 401(k) is the ability to take
a loan against your plan that is to be repaid with after-tax funds at a
pre-determined rate of interest. As long as the loan is paid in full, the loan
will not be taxed or subject to the early-withdrawal penalty. General terms of
these loans are that the loan be extended for no longer than five years, that a
reasonable rate of interest is charged, and that equal payments over a
quarterly basis are made over the life of the loan. If for any reason you
default on the loan, the loan balance is taxed as a distribution and is
penalized as an early distribution.
Distribution Requirements
Once you reach age 59 ½, they can begin to take normal distributions. It is at
this time that the withdrawals are taxed as ordinary income. Minimum
distributions are required if you are age 70 ½ and have yet to take
distributions from the account. The distribution amounts are based on IRS time
tables and other relevant factors.
Rollover Restrictions
When you terminate employment with a company, you are given the option to
rollover your 401(k) into a new company’s plan or into a Traditional IRA. The
most common decision is to roll the account into a Traditional IRA. IRA
accounts offer more investment choices than 401(k) plans and are not subject to
restrictions imposed by the company.
The most efficient method of a 401(k) rollover is a direct rollover. This is
where the company directly transfers your retirement funds to your IRA provider
or your new employers plan. By doing this it eliminates the chances of federal
tax withholding or incurring any early distribution penalties.
Potential Penalties
The most common penalties are for early withdrawal or a failure to take a
required minimum distribution. Early withdrawal results in a 10-percent penalty
on the amount distributed along with normal taxation on the amount withdrawn as
ordinary income.
The most severe penalty that the IRS applies is upon failure to make the
required minimum distribution, which is equal to 50-percent of the amount that
should have been withdrawn.
 |
All content in this article is supplied
by Investools. To learn more about their investor education offerings, please
visit www.investools.com |
|
