A 401k is a type of employer-sponsored retirement plan. It is a way for employees to save for their retirement by having a certain percentage of their paycheck withheld by their employer and deposited into the company's plan. Employers can choose to match the employee's contributions and thereby share the profits of the company with their employees. The plan is usually operated through an investment firm.
For example, Acme Company's 401k plan allows employees to contribute part of their paycheck into the plan. Acme will match incrementally up to 3% of the employees contribution. If the employee contributes 3%, Acme will contribute 2% to the employee's account. If the employee contributes 4%, the company will contribute 2.5%, and if the employee contributes 5% or more, the company will contribute 3%. The employer's contributions are called matching contributions.
As you can see, if an employer provides matching contributions, the employee can increase the amount of money he receives from his employer above and beyond his salary. For example, if Joe makes $30,000 in 2007 and contributes 5%, Acme will contribute an additional 3%. As a result, Joe will receive $30,000 plus $900 additional money from Acme's matching contributions. Joe's total compensation will be $30,900, not $30,000, simply because he participates in Acme's plan.
How does a 401k work?
Your employer withholds a certain amount of your paycheck and deposits that money, along with any matching contributions, into your 401k account. The money in the plan is invested in various financial instruments, such as mutual funds. The money stays in the account until you reach a certain age when it is legal to withdraw the money, or until you meet any of the several exceptions to the age rule. Since the money will be in the account over a period of years, this causes the account to earn money through compounding, so your account grows not only through your regular contributions made from your paycheck but also by earning interest or dividends.
How do I make contributions to a 401k?
You make a contributions through your employer. If you decide to participate in the plan, you will determine what percentage of your paycheck that you want to be deposited in your account, and your employer will withhold that amount from each paycheck you receive. The employer then deposits the withheld money into your account, along with any matching contributions, so contributions are made to your account each pay period.
Are there any limitations to making a contribution to a 401k?
Yes, there are limitations. You are limited by IRS rules and also by whatever rules your employer implements in his plan.
IRS Contribution Limitations
For 2007, the limit for contributions to defined contribution plans is the lesser of:
1. 100% of the participant's compensation, or
2. $45,000.1
Employer Limitations
When your employer sets up his plan, he can place limitations on contributions. The plan can be set up so that employees can only contribute up to a certain percentage of their paychecks. A common example is the limitation on matching contributions the employer will provide.
What is a company match?
A company match is when employers agree to contribute certain amounts to your 401k in addition to your own contributions. Employers may decide to make a contribution above and beyond what you decide to contribute. This is one version of what is commonly known as profit-sharing since the company gives you additional compensation toward your retirement. Because you are part of the company and your work helps contribute to any profit the company makes, employers use matching contributions as a way to reward employees for their input to the company's bottom line. This can also provide an incentive for employees to work harder in order for the company to make more money.
If my employer goes out of business before I retire and receive distributions from my 401k, what happens?
401k plans are covered by the Employee Retirement Income Security Act of 1974, or ERISA. Generally, if an employer goes out of business or becomes bankrupt, the employer's creditors receive the employer's assets to settle debts. However, ERISA protects your plan money from those creditors. The creditors generally cannot get any money from a 401k plan to settle debts of a bankrupt employer.2
When can I withdraw my money from a 401k?
You can withdraw your money at any time. However, if your withdrawal is an early distribution, you will have to pay an extra tax on the withdrawal.3
What is an early distribution?
An early distribution is any money taken out of your 401k before reaching age 59 ½. Early distributions are subject to a 10% tax penalty in addition to regular income taxes, so if you withdraw $5,000 when you are 45, you will have to pay $500 as a tax penalty. However, as discussed in the following question, there are some exceptions that allow you to withdraw money before age 59 ½ without owing the 10% penalty.4
Are there any other circumstances when I can withdraw my money before age 59 ½?
Yes, there are some exceptions to the age rule. You will not owe the 10% tax on an early withdrawal if the withdrawal is:
1. Made to a beneficiary after your death.
2. Made because the employee has a qualifying disability.
3. Made as part of a series of substantially equal periodic payments.
4. Made after separation from service if the separation occurred during or after the year when the employee reached age 55.
5. Made to an alternate payee under a qualified domestic relations order (QDRO).
6. Made to an employee for medical care.
7. Timely made to reduce excess contributions under a 401k plan.
8. Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).
9. Timely made to reduce excess elective deferrals.
10. Made because of an IRS levy on the plan.
11. Made a qualified reservist distribution.
How do you maintain a 401k?
You maintain your account by making contributions to it. You can only make contributions through your employer. The contributions are withheld from your paycheck, and any matching contributions from your employer are deposited into the plan by your employer.
If you leave the company, you can choose to leave your 401k as it is, or roll it over into a Traditional IRA.
If I quit my job where I was participating in a 401k plan, what happens?
The money you contributed to the 401k is always yours, regardless of how long you have worked for the employer. Generally, an employer requires that you work a certain number of years before you are vested, which simply means that you are legally entitled to the employer's matching contributions. Therefore, depending on your employer's rules, you may or may not be able to keep the employer's matching contributions.
There are several things that you can do with your account after leaving your job. One is to leave the 401k in your employer's plan until you decide what to do with it. You can even leave it there until you reach age 59 1/2 and can begin receiving distributions. However, your former employer may charge you fees for maintaining your 401k for you. Check the plan agreement for details about your former company's specific rules.
Another thing you can do is rollover your 401k into a Traditional IRA. Contributions to Traditional IRA's receive the same type of tax deferral treatment as contributions to 401k's, so you may be able to rollover your money into a Traditional IRA and not owe additional taxes.5
What if I am laid off or fired?
Your options include any of the solutions discussed in the previous question. Despite being fired or laid off, the contributions that you made to your account are still your money, so you are legally entitled to all contributions that you made. However, depending on the rules of your plan, you may not be entitled to the employer matching contributions.
Can I start a 401k if I already have an IRA?
Yes, you absolutely can participate if you also have IRA's, Traditional or Roth.
How does a 401k affect my federal income tax?
Contributions are considered "elective deferrals" of income, so you do not pay any federal income tax on them in the year you make the contribution. For example, John contributes $1,000 to his 401k in 2007, and his employer contributes $200. John's salary for the year is $30,000. He will pay federal income taxes on $29,000 only, which is his salary minus his $1,000 contribution.
However, Uncle Sam will never let you get away completely tax-free. When you take distributions from your plan during retirement, you will pay federal income taxes on that money then. For example, if Susan is age 65 and receives a $10,000 distribution in 2007, she will owe taxes on the $10,000. However, when she contributed to the plan years ago, she did not have to pay any taxes on the money she contributed then.6
Do I have to withdraw money at a certain age?
Yes, you must start withdrawing money by April 1 of the year after:
1. You reach age 70 ½, or
2. You retire from the company maintaining the 401k plan.7
What happens to my 401k after I die?
You may designate beneficiaries who will inherit your account after your death.8
Why participate in a 401k? Why not just invest that money in mutual funds?
By participating, you receive tax benefits that you would not receive by investing your money in mutual funds on your own. The money you contribute is not subject to income tax. Therefore, you end up paying fewer taxes by participating in the plan than if you bought mutual funds on your own. For example, Joe works for ABC Company. He makes $30,000 and contributed $1,500 to his 401k. He will owe federal income taxes on $28,500 only, not on his full salary of $30,000. He gets to deduct the contributions from his income before calculating his taxes.
Another reason to participate is that in most plans, employers match a portion of your contributions, so it is as if your employer is giving you free money simply by participating! For example, Joe of ABC Company makes $30,000 in 2007 and contributes $1,500 of that salary to his 401k plan in 2007. ABC Company provides matching contributions of $1000, so Joe really makes $31,000 in 2007, not just his $30,000 base salary.
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