Investing in your future takes on many shapes and forms. One reliable method of saving for your later years is contributing to a plan specifically designated for retirement.
While there are various savings vehicles available, the most common retirement savings plans fall into two categories: 401(k)s and IRAs. Although IRAs have their own level of complication, discussions about 401(k)s are often minimized. Despite employer involvement in 401(k) planning, self-education is a prudent and necessary step.
The more you know and understand about retirement savings options, the greater your financial IQ will be. With that freedom, you can begin on a path of unprecedented stability and security.
Below are three questions that must be explored when considering 401(k) plans.
1. What’s The Difference Between A 401(k) And An IRA?
Both account types are retirement savings vehicles. The main difference between the two is that 401(k) plans are offered by an employer, while IRAs (Individual Retirement Accounts) exist outside of the employment environment. Anyone who has taxable income can establish an IRA, regardless of whether his or her employer offers a retirement plan.
Contributions: 401(k)s follow different contribution patterns than IRAs. While IRA contributions are determined by what you decide to add (and limited by the plan itself regarding your age and income), 401(k)s are set up so that part of your salary is added (before income taxes are subtracted from your salary). One of the benefits to 401(k) plans is that some employers offer to match contributions.
Taxes: 401(k) contributions are considered tax-deferred, meaning that you don’t pay taxes on the contribution amount until you withdraw from the account. IRAs come in two forms: Traditional and Roth; Traditional IRAs are tax-deferred, while Roth IRAs are taxed on the front and have tax-free growth.
Withdrawals: As with taxation, IRA withdrawal regulations vary depending on if the account is a Traditional IRA or a Roth IRA. For 401(k)s, withdrawal regulations vary plan to plan. Typically, once retirement age is met, withdrawals can be made penalty-free; prior to retirement age, additional taxes and an umbrella penalty fee may be incurred.
2. What Happens If I Switch Jobs?
There are basically three options that you can chose if you leave a place of employment that offered a 401(k) retirement plan.
Empty The Account: While withdrawing all funds and closing the account has its appeal, there are consequences attached to this option. Not only will all applicable taxes be owed, you could incur a 10 percent penalty if you are not at the age of retirement. The regulation for early withdrawal remains in place regardless of whether you keep the account open or are withdrawing in order to cash out.
Transfer To A New Retirement Plan: If you are leaving one 401(k) providing employer for another, you can complete a “direct rollover,” where the funds accrued will transfer into your new employer’s 401(k) plan account. Another option is to roll over the savings into an IRA.
Let It Be: As with emptying the account, leaving the account as is tends to be more complicated than it appears. Depending on how much money is in the account, your employer has the option to automatically transfer the funds into a new IRA (Individual Retirement Account) for you. This typically applies if the amount is less than $5,000. If the amount in the account exceeds $5,000 and you have not yet reached retirement age, leaving the account in place is simple enough; no taxes would be due until a withdrawal is made.
3. Can My Employer Terminate My 401(k) Without My Consent?
Since no federal or state regulations are in place requiring employers to offer retirement plans, by law, employers can terminate their offered 401(k) plan.
Despite this potential upset, employees are protected to a degree if this occurs. According to the IRS, “Upon plan termination, participants must be immediately 100 percent vested in all accrued benefits.”
In other words, the account will not disappear and the employer will no longer have any ownership in the account. Termination of a plan will require the employee to make a decision regarding the account, similar to the decision he or she would make when changing employers.
The benefits of a 401(k) are extensive, particularly if an employer offers any sort of matching contribution. Yet, with all things financial, even the most idyllic plans are never as straight forward as they appear. Educating yourself instead of solely relying upon other people’s advice is the surest way to protect your assets. Invest in yourself; empower your future; be proactive.
This piece is a product of collaborative efforts between Benzinga’s Managing Editor Joe Young and Personal Finance Writer Rebecca Sheppard.
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