June 17, 2024

401(k)’s: What You Need to Know

The 401(k) — named for a section of the tax code — is a type of defined-contribution plan, where you make regular contributions into a retirement account that you own. You make all of the investment decisions, unless you hire a professional to help you out. This differs from a defined-benefit pension plan, which provides workers with a guaranteed paycheck (or lump sum) in retirement — and the onus is on the employer to finance it. Many companies have phased out pension plans in recent years given their high costs, which means that most people need to worry about financing their own retirement.

While retirement plans differ — and go by an alphanumeric soup of names — most medium-sized and large companies offer 401(k)’s. There are two similar varieties — 403(b) and 457 plans — with the former offered to certain employees of public schools, hospitals and certain tax-exempt organizations, while the latter is provided to governmental employees. If you work for a small business, you might be offered a different type of plan, but the inner workings and concept will most likely be similar to those of a 401(k).

Employer-sponsored plans are usually the place you want to start saving for retirement because many employers match a piece of your contribution — and that serves as a guaranteed return on your money. They also provide certain tax benefits. Traditional 401(k)’s and similar plans allow employees to make their contributions on money that has not yet been taxed. So you’re effectively reducing your taxable income by the amount you contribute.

The mechanics of a 401(k) plan are relatively simple: An employee must first decide the amount to contribute, typically measured as a percentage of salary. The contributions are automatically deducted from your paycheck, but they’re subtracted from your gross income (before you’ve paid any income tax). By deferring, say, 10 percent of your salary, you’re also reducing your taxable income by 10 percent. So if you earn $60,000 annually and make a 10 percent contribution, you will be taxed on only $54,000. Contributions are held in your account and are invested in any of the mutual funds on a menu selected by your employer. (If new employees do not sign up for the company plan, some employers will sign them up automatically.)

Most 401(k) plans provide matching contributions. So if you set aside 10 percent of your salary, your company should make a matching contribution each time you do. Most companies that provide matching contributions match up to 3 percent of pay, but they use different formulas to get there. For instance, some companies will match you dollar for dollar up to 3 percent of pay, but more companies tend to pay 50 cents for every dollar you contribute, up to 6 percent of your pay.

All of the money inside the account grows tax-deferred, but ordinary income taxes will be owed on all withdrawals. If you want to avoid paying any penalties, you must wait until you are 59 1/2 to start tapping your 401(k). Individuals who leave their employer during the year of their 55th birthday or later may also begin to withdraw funds penalty-free.Before then, you’ll pay a 10 percent penalty fee on top of ordinary income taxes.

ROTH 401(K)

An increasing number of employers are adopting what are known as Roth 401(k)’s. These operate the same way traditional 401(k)’s do, but employees make their contributions with dollars that have already been taxed, and everything inside grows tax-free. No taxes are owed on withdrawals — but you must be at least 59 1/2 and have held the account for five years or more.

If your employer makes matching contributions, those will be put into a separate account, similar to a traditional 401(k), because that money has not been taxed and can not be commingled with your after-tax contributions. When you withdraw your match money, you’ll pay ordinary income taxes just as you would with a regular 401(k).

There are calculators that will help you figure out which 401(k) makes the most financial sense, but it really comes down to whether or you think you will be in a higher tax bracket in retirement than you are now. A better question might be whether you think federal deficits will push tax rates higher over all. Either way, if you expect to pay more in taxes in retirement, a Roth 401(k) probably makes more sense. Or, you can simply diversify — from a tax perspective — and contribute to both plan types.


The maximum you can contribute to your 401(k) in 2009 is $16,500. For those 50 and older, you can contribute another $5,500, known as a “catch-up contribution,” as long as your plan allows them. In 2009, the total amount that can be contributed by both you and your employer cannot exceed the lesser of 100 percent of your salary or $49,000.


Most plan sponsors provide programs that can lend you money from your accumulated funds, but your employer can limit the reasons for borrowing to, say, buying a home, medical bills or higher education. You are usually allowed to borrow up to half of your vested account balance, up to $50,000. (Vesting is the amount of time you need to be employed with your company before you have access to their matching contributions; these contributions usually vest over several years).

Loans generally need to be paid back within five years, though you should contact your employer because rules will vary by company. Interest rates are usually priced at the prime rate plus one percentage point, but the interest is paid back to yourself. Keep in mind that if you leave your company before you’ve repaid your loan, you’ll need to repay it within 60 days or so. If you fail to do so, it will be treated like a withdrawal and you will owe income taxes and any penalty fees.

In some cases, you might qualify for a hardship withdrawal, which means you can take money out if you encounter certain situations that qualify. But you will still owe the 10 percent penalty fee (if you are under age) and income taxes on all withdrawals. Qualifying hardships usually include: medical bills that will not be reimbursed by insurance for yourself, your spouse or dependents; foreclosure and eviction costs; buying a primary home; costs to repair your primary home; college costs; funeral and burial expenses. There are some cases where you might be able to avoid the penalty fee, for instance, if your medical bills not covered by insurance exceed 7.5 percent of your income. But check with your employer first.

If your employer happens to go kaput, your 401(k) plan would most likely be terminated. But your money is protected — and cannot be touched by your bankrupt employer.

If you leave your job, it might make sense to roll your 401(k) funds over into an individual retirement account. If your balance is less than $5,000, your former employer may require that you do so anyway.

Article source: http://www.nytimes.com/2008/12/17/your-money/401ks-and-similar-plans/primer401k.html?partner=rss&emc=rss

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