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Retirement 101: The Basics of 401(k)

401k_1Love her or hate her, we all agree that Suze Orman wagging a finger while saying  “Denied!” is one of television’s most iconic images. And what advice does she offer each and every time? Never, ever withdraw from your retirement savings before it is due. This  really makes sense, and we’ll explain why in this essential guide to retirement savings.

What is 401(k)?

401(k) is an employer-sponsored retirement savings fund. They key word here is employer. No employer, no 401(k). It’s as simple as that. There are individual 401(k) plans but these require you to be a business owner, which also makes you an employer.

401(k) is named after a special section of the Internal Revenue Service code which offers special tax advantages. It allows the employee to make contributions to the plan with pre-tax money, which means that you do not pay taxes on the amounts you contribute to the 401(k) plan.

If you make $60,000 per year and you put $5,000 of that into your 401(k) plan then you only have to pay taxes on the remainder — $55,000. This, on its own, is already a big boost to your financial health. All other things being equal, a $60,000 income will owe $8,429 in taxes while $55,000, on the other hand, will only be taxed $7,179. That’s a reduction of $1,250. Quite a tidy sum, yes?

But that’s not the only tax advantage. All taxes generated by your 401(k) account are tax-deferred. You do not pay taxes until much later.

Is 401(k) tax-free?

No. This cannot be overemphasized.  It’s not tax-free, only tax-deferred. This means that you won’t have to pay any tax for all the money that you put into your 401(k) until you withdraw it. Then it becomes taxed like normal income. If, for example, you withdrew $10,000, it would be treated like you earned that $10,000 from your job.

You’ll need to keep this in mind when planning for retirement. If you need $40,000 per year to sustain your standard of living, you will need to withdraw close to $50,000 because part of that will go to taxes.

How much can I contribute to my 401(k)?

The maximum amount is set yearly by the IRS. For 2013, you can contribute up to $17,500 as an elective deferral to your employer’s 401(k) plan. Additionally, if you are 50 or older, you can contribute an additional catch-up contribution of $5,500.

While most Americans will never be subject to them, there are additional rules and regulations for certain individuals classified as highly compensated employees. The threshold is $115,000 in 2013. The 401k earnings maximum compensation that can be used for contributions is $255,000. Income above $245,000 does not count for 401(k).

Why so? The IRS wants to ensure that low-income employees benefit from 401(k). A yearly discrimination test (the ADP or Actual Deferral Percentage) is conducted for all companies with a 401(k) program. The total contributions of all highly compensated employees should not exceed the total contributions of all non-highly compensated employees by 2%.

What’s my employer’s role in 401(k)?

Some (but not all) employers choose to match your contributions to 401(k). These matching contributions are mostly not a dollar from your employer for a dollar of your contribution. Employer’s matching contributions also have a ceiling. Many employers choose to top up a dollar of your contribution with 30-50 cents of their own with a maximum limit of 6% of your total gross income. In very rare circumstances, some choose to match it dollar for dollar but caps the matching contribution at 5%.

Here’s a tip. If your employer offers a match, max it out. That means you contribute as much as you can up to the limit of matching. The logic is simple. If you have zero contributions, you get zero from your employer. The higher your contribution, the more you get from your company.

One important concept to always keep in mind is vesting. It’s the amount of time your employer’s matching contribution becomes your own. However, any contribution you make from your paycheck is your own. A common vesting schedule is 20% on the first year, 40% on the second, 60% on the third, 80% on the fourth, and 100% on the fifth years. This means that if you leave the company after 3 years, you take with you 100% of your own contributions but only 60% of your employer’s match.

Essentially, your employer is the administrator of your 401(k) funds. In a sense, it doesn’t totally belong to you. Any transaction that you need to do with your 401(k) account will have to go through your employer.

What if I change employers?

If you quit or leave your current job, officially called “terminating employment,” you’ll need to put your 401(k) elsewhere. Be very careful with your decisions at this point because they’re usually irrevocable and might have huge tax consequences.

Rollover is the common term for transferring your 401k account to a new qualified account, usually one you opened with a new employer. Rollovers are effectively trustee to trustee transfers.  A trustee is simply a company that services your account. Any 401(k) plan that you transfer to has a trustee. If you transfer the whole balance from your 401(k) to another qualified account there are no taxes and everything should be fine. Your balance may be transferred electronically to the new account.

If a check is made out, always remember not to have it made out to you! If at the end of your employment you get a check from your company payable to you, you only have 60 days to get that money into another qualified account or it counts as a distribution and therefore taxable.

What if I withdraw my retirement savings early?

This is where Suze Orman says denied! And for greater emphasis – denied, denied, denied. Your 401(k) isn’t for house remodeling, a three-week European vacation, or your only daughter’s wedding. It’s for making sure you’re financially stable after retirement. That’s why there are controls in place to ensure that you’re not tempted to withdraw your funds before the proper time. A penalty of 10%, to be exact. That’s on top of the income tax on the amount that you withdrew.

Let’s say that as your 50th birthday gift to yourself you took out $25,000 to redo your whole kitchen because you have to have those Spanish tiles and matching cedar cabinets. You’ll have to $2,500 penalty for that, plus pay regular taxes. In the 25% tax bracket that works out to $6,250. That $25,000 withdrawal will cost you $9,000 overall so your net proceeds will only amount to $16,000! Now it’s plain to see why Suze Orman and just about everyone else say taking money from your 401(k) is a bad idea.

Are there other similar retirement funds?

Yes there are other retirement fund alternatives.

  • 403(b) plans are offered by school districts and other educational institutions, although certain non-profit organizations may offer them. It’s also called a Tax Sheltered Annuity plan, or TSA plan. It functions much like a 401(k) plan. The main differences are in the employer side. 403(b) plans are easier to administer and do not require a discrimination test because the objective is universal availability – all employees must be permitted to make salary-deferral contributions.
  • Traditional IRA. Unlike 401(k), you don’t need an employer to set up an individual retirement account (IRA). It is held at a custodian institution such as a bank or brokerage, and may be invested in anything that the custodian allows (e.g. certificates of deposit, stocks, and mutual funds). Like 401(k) and unlike Roth IRA (discussed below), contributions made to a regular or traditional IRA are tax deductible, and withdrawals are taxed as income.
  • Roth IRA. Suze Orman’s favorite, without doubt. It’s been called the greatest wealth-building tool available to the ordinary person, and rightly so. Unlike 401k, Roth IRA allows you to withdraw contributions tax-free. All the earnings from investments made in your Roth IRA are also tax-free. The difference is that your contributions are not tax-deductible. In effect, your contributing money you make after taxes. This really isn’t such a bad thing. You’ll end up paying higher taxes on your income, of course, but when you do withdraw there’s no danger of being shunted to a higher tax bracket. That kitchen with Spanish tiles and cedar cabinets that you wanted? If you withdrew the $25,000 from a Roth IRA account you’ll get all of it. Compare that with only $16,000 from 401(k).
  • Maximum IRA contributions. For 2013, the maximum you can contribute to ALL of your traditional and Roth IRAs is the smaller of: $5,500 ($6,500 if you’re age 50 or older), or your taxable compensation for the year.
  • Traditional IRA vs. Roth IRA. Traditional IRAs have most of the features of 401(k) accounts, primary of which are contributions being tax-deductible and withdrawals taxable. This is also what distinguishes it from Roth IRA. But there’s one feature which makes it stand out it from Roth IRA. It’s available to everyone; there are no income restrictions. Roth IRA is only available to single-filers making up to $95,000 or married couples making a combined maximum of $150,000 annually.
  • Roth IRA + 401(k). Yes, you can have both Roth IRA and 401(k) accounts. The ideal retirement plan is to save enough money in 401(k) to provide for monthly living expenses, including your fun and leisure, during retirement. Then, max out a Roth IRA account every year. Don’t count that money for monthly income. Let the Roth IRA grow and get money from there when the unexpected happens.

When is the correct time to withdraw?

The earliest age at which you can withdraw funds without penalties is at 59½ years old. There’s also a magic age for mandatory withdrawals. You can’t keep your untaxed money stashed away forever. Starting a year after you turn 70½ you have to start taking out a minimum amount of money out each year. It’s called the Required Minimum Distribution or RMD. “Distribution” is the term for money taken from a 401k account.

Determining your RMD is a complicated matter so don’t even try to do the math yourself. It’s based on life expectancy tables similar to those used by life insurance companies. The longer the life expectancy, the smaller the required minimum withdrawal because as each year passes, the account grows smaller from distributions made against it. It’s computed as a percentage of the total value of your 401k account of the year previous. Get a professional (accountants or financial planners) to help you out with the figures.

Should I take out a 401(k) loan?

Never, and here’s why. 401(k) plans require you to pay back your loan in full within 90 days of your termination of employment. Whatever your reasons for leaving might be, you’ll owe the whole balance in 90 days. If you don’t pay then it counts as a withdrawal and if you aren’t 59½ yet, that means you owe the taxes plus a 10% penalty.

Let’s do the ugly math. You take $20,000 to remodel your kitchen. With Spanish tiles and cedar cabinets, of course. So you keep your job and spend the next 16 months paying it back at the rate of $200 per month for the principal (yes it’s a loan so you need to pay it back, and were not even counting interest here) you’ve paid back just $3,200. At this point you get a dream job offer and you decide to leave. You still owe $16,800, right?

Well, you’ll need to pay back that $16,800 all at once. If you had that much lying around, then you probably wouldn’t have taken the loan in the first place. If you don’t pay it all back, it will be counted as income that will be taxed an extra $3,360 if you’re in the 20% bracket. This $16,800 might even push you to the next higher tax bracket.

Don’t even think about it. If you’ll be miserable for the rest of your life without those Spanish tiles in your kitchen, find some other way of financing the remodeling.

Is 401(k) for me?

Definitely yes, if you’re employed. In fact, 401(k) is one of the most important things you should be looking for in a prospective employer.

Sources:

  1. New York Times: Your Money
  2. Internal Revenue Service: 401(k) Plans
  3. Wikipedia: 401(k), Roth IRA, Traditional IRA, 403(b)
  4. Pension Plan Limits for the Tax Years 2007 – 2013

Does the prospect of retirement worry you? Are you prepared? We’d like to hear your 401(k) story.

 

Nestor Gilbert

By Nestor Gilbert

Nestor Gilbert is a senior B2B and SaaS analyst and a core contributor at FinancesOnline for over 5 years. With his experience in software development and extensive knowledge of SaaS management, he writes mostly about emerging B2B technologies and their impact on the current business landscape. However, he also provides in-depth reviews on a wide range of software solutions to help businesses find suitable options for them. Through his work, he aims to help companies develop a more tech-forward approach to their operations and overcome their SaaS-related challenges.

2 Comments »
imaupser says:

I have a teamsters/ups 401(k) for 15 years now and it just dawned on me, that i am not sure if I am receiving dividends on my elected allocations I put my money into. so maybe I am not getting the max return on my investments. Please chime in, anyone who can tell me if ill be ok in the long run.

Reply to this comment »
steve says:

your statement that the earliest age you can withdraw is 59.5 is incorrect. you can start withdrawals, penalty free at the age of 55 or older if you were still employed with the company that you built up your 401k with when you turned 55. furthermore, you can actually withdraw funds penalty free at any age, as long as you continue to make those withdrawals for the same amount and at the same intervals for 5 years, or until you reach 59.5. this is called "substantially equal periodic payments". i really don't understand why these options are never spelled out for people, if it's an attempt to "dumb it down" i don't think that passes the "journalistic integrity" test. if the author isn't aware of them they shouldn't dive into this important subject matter, wouldn't you agree?

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