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401(k) Plan |
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WIKI ANALYSIS
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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
A 401(k) plan helps a working person in the US save for retirement. It is very similar to an IRA except for the fact that is administered by the employer. Personal contributions are often matched by their employer. Transactions and profits within the plan are not taxed in any way, like a Roth account.
Contributions may be claimed as a tax deduction to reduce taxes, so the savings is considered to be from pre-tax income. Cash is taxed as income on withdrawal. This is different from the Roth 401(k), where the account holder deposits after-tax income, and withdraws it tax-free. A person is allowed to have both a 401(k) and an IRA.
Most 401ks are participant-directed, which means that the employee can select from a number of investment options, such as mutual funds, bonds, and money market investments. The employee usually has the option to change allocation between these asset classes. Some 401ks allow investment changes about once a quarter, others may allow more frequent changes. In trustee-directed 401(k) plans, the employer appoints trustees who make investment decisions on behalf of all employees.
For income below $200,000, individuals can 'defer' up to $15,500 for the year 2008 and $16,500 for 2009. Individuals above 50 can contribute an additional $5,000 in 2008 and $5,500 in 2009. Total contribution, i.e. contribution by employee plus employer contribution, cannot exceed the lesser of $46,000 or the employee's annual salary in 2008.
The employee cannot withdraw from the 401k until he/she reaches the age of 59½, except under special circumstances. Withdrawals before that age are typically subject to 10% penalty (as well as income taxes). Starting at the age of 70½, employees must take minimum distributions, i.e. they are required to withdraw, from the 401k account. This applies to both regular 401(k) and Roth 401(k) accounts. This is mandatory, unless the account holder continues to work for the employer who sponsored the plan at the age of 70½. For a Roth 401(k) account, mandatory required minimum distributions do not apply if the assets are rolled over to a personal Roth IRA after separation of service.
Benefits of a 401(k) plan
- The tax reduction from contributions and increased tax on withdrawals creates a strong emotional incentive to save and not touch the savings until retirement.
- The tax recovered by claiming the contribution as a tax deduction is NOT a benefit. It is more like a loan. The withdrawal triggers tax that effectively pays back the loan plus all the income it earned - but not the income earned by the original after-tax savings.
- The profits within the plan are never taxed. This benefit equals the amount of tax that would have been paid in a taxable account. This exactly equals the benefit from a Roth.
- There is a benefit if the marginal tax rate used for the withdrawal is lower than the rate used for the contribution. This equals the $withdrawn * the difference in %rate. There is a penalty if the reverse is true.
- Employees are immediately 100% vested with their own tax deferred contributions, and if they leave their employer, they can roll their account into an individual personal IRA, or to a new company's 401K.
- Some plans offer "matching" contributions from their employer, i.e. the employer will contribute an amount proportional to the individuals own contribution. For example a 5% match means that the employer will match contributions up to 5% of the employees annual salary. In other words, if someone earns $50,000, and contributes $4000 to his/her 401(k), the employer will contribute a maximum of $2500 (5% of salary). In some cases, the match is not dollar-for-dollar and employers may only match 50%, or 25% of the employee's own contribution. Many would argue that the company match is the greatest advantage of a 401K as the immediate 'return' generated by the matching donations allows for faster acquisition of capital.
- Some plans offer direct loans, hardship loans and disability loan provisions against the 401(k).
Disadvantages of a 401(k) plan
- Investment choices in 401ks may offer a limited number of investment choices to choose from.
- Since taxable income is deferred from 'when earned' to 'when withdrawn' in retirement it may reduce your eligibility for income-tested social benefits. This 'cost' is usually calculated by considering the value of the benefits lost as taxes when determining the marginal tax rate on withdrawal.
- Withdrawals from any retirement plan: 401k, 403b, 457 plan or IRAs are income taxable when the money is withdrawn. If the person is below the age of fifty nine and a half years (except hardship cases and other special situations) there is an "IRS early withdrawal 10% penalty" in addition to deferred taxes.
- Exceptions include: the death of the employee, total and permanent disability, separation from service in or after the year the employee reached age 55, a qualified domestic relations order, and deductible medical expenses, exceeding the 7.5% floor.
- Employers have the option to restrict individuals with less than 1 year of service, union members, non US citizens, part-time workers etc., from being eligible for the plan.
How to start a 401(k) plan
401(k) plans are offered through an employer. By participating in this plan, an employee authorizes the employer to retain part of their salary for these plans. Most human resources departments will have details on starting such an account with the employer.
When leaving an employer, a employee can choose to leave the 401(k) with an old employer -- in many cases, employers will charge a fee for managing 401(k) plans of ex-employees. An individual can also cash out his 401(k), but this would result in a penalty of 10%. The best option is to rollover a 401(k) from one employer to the next. http://www.bestcashloans.org.uk/
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