Technically, a 401(k) plan is a tax qualified retirement plan sponsored by your employer which allows you to make pre-tax contributions to an account for your retirement. In many respects, the account is similar to an Individual Retirement Account (IRA). The name of the plan comes from the section of the Internal Revenue Code which authorizes these plans.
First, there are tax benefits. By contributing to the 401(k) plan, you actually reduce the amount of income taxes you owe. Consider the following example:
Jack Jill Monthly Paycheck 2000.00 2000.00 FICA & SDI Taxes -170.00 -170.00 Federal & State Withholding (20%) -400.00 -375.00 Monthly Living Expenses -1330.00 -1330.00 Left for Savings or Plan 100.00 125.00
In this example, after taxes and living expenses, Jack saves $100 per month. Jill, with the same income and expenses, is putting $125 per month into the 401(k) plan. The difference is that no income tax is withheld on the money Jill puts into the 401(k) plan. In effect, Uncle Sam has given Jill $25 for joining the Plan. Though not illustrated above, Jill may also have lowered her tax bracket.
If Jill only contributed $100 (the same as Jack saves), she would have an additional $20 of spending money.
Another significant advantage is that the earnings in 401(k) accounts accumulate tax free. No taxes are due until amounts are withdrawn. Tax deferred growth keeps all of your account working for you. If you were in a 30% tax bracket (Federal and State), your investments outside the plan have to grow at a 30% higher rate to match a tax deferred rate. In a 30% tax bracket, if your account earned 6% each year for ten years, it would be 10% larger than a non-tax sheltered account.
In many respects, your 401(k) plan is like an IRA. In other ways, there are significant advantages.
For example, you are currently allowed to contribute $5,000 ($6,000 if 50 or older) per year to an IRA. If your spouse is covered under another retirement plan, you may be restricted from contributing anything to an IRA. The limit for 401(k) deferrals for is $0, or $0 for those 50 or older, subject to limitations explained later.
If you are like most IRA holders, you wait until April 15th to contribute. In effect, you give up 15 months of potential earnings. Some years, you may not have $5,000 to spare by April 15th. By having your contributions deducted from pay and contributed throughout the year, your contributions are working for you all year long. And because the contributions are spread throughout the year, they are hardly missed.
If you terminate employment, your account is eligible to be transferred to an IRA account, further sheltering your funds from income tax.
In addition, the plan may include a loan feature, allowing you to borrow from your account. This is not possible under an IRA. And your account is also protected from creditors in bankruptcy.
Some 401(k) plans include a Matching Contribution from your employer. A typical example would be that the employer contributes 10 cents for every dollar you contribute, up to a limit. This is the equivalent of earning 10% on your money before any investment gains. In some cases, matching contributions are made or not at the employer's discretion.
This varies from company to company. There are two basic ways the contributions are handled. One method is to set up an individual account in your name at a brokerage company. The other is to pool your contributions with other participants' contributions and invest them based on an allocation formula you select. There are advantages and disadvantages to each.
Under the separate account method, you are in direct contact with a brokerage company. You give the broker directions as to how to invest your account. You receive monthly statements directly from the brokerage. You may even be able to invest on-line. The disadvantage to this method is, until sufficient funds are accumulated, your investment options are limited because most mutual funds have minimum initial deposit requirements, and commissions when buying a few shares of stock are usually higher than when buying 100 share lots.
Under the pooled account method, you select what percentage of your total deferral to be invested in various funds. There may be money market, government bond, stock mutual funds, etc. The advantage to this arrangement is that, since contributions among the various investment options are pooled with other participants', you are able to invest as little as $1 in many different funds. The disadvantage is that you may only receive account statements once or twice a year, and your choice of investments is limited.
Being part of a retirement plan tax favored by the IRS, certain rules and restrictions apply.
There are limits on the amount and percentage you are allowed to defer in any year. For , the limit on deferrals is $0. All contributions to the plan for your account, which may include your deferrals, matching contributions, and non-elective (profit-sharing contributions) may not exceed 100% of your pay or $0. With "Catch-up" deferrals, the limit is $0
If you are a highly compensated employee, your deferrals may be limited by the amount of deferrals made by lower paid employees.
Withdrawals from your account are not allowed until you reach retirement age, become disabled, die or terminate employment unless they are taken as a loan or because of hardship. Hardship is defined as an immediate and heavy financial need, including medical expenses, purchase of a home, tuition costs or to prevent an eviction or foreclosure.
Distributions are taxed as income unless transferred to an IRA. There may also be a 10% excise tax due if the withdrawals are made before age 59 1/2.
Younger people seldom consider retirement planning a high priority. However, the earlier you get started, the more comfortable your retirement can be. This is due to the effect of compounding interest.
The following chart shows what $100 a month would grow to become at age 65 by earning 6% per year, based on various starting ages.
Amount Percent Starting Dollars Account From From Age Put In Balance Interest Interest 25 48,000 199,149 151,149 76% 30 42,000 142,471 100,471 71% 35 36,000 100,452 64,452 64% 40 30,000 69,299 39,299 57% 45 24,000 46,204 22,204 48% 50 18,000 29,082 11,082 38% 55 12,000 16,388 4,388 27%
In this example, the 25 year old has contributed only $6,000 more than the 30 year old, yet his account is more than $ 56,000 larger. The earlier you start the better!
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