401k Plans: Get the Facts
A crucial, but vital component of your career includes planning for its end - your retirement. Most people accomplish this financial feat, in part, by opening and contributing to an individual retirement account (IRA). Many types of IRAs exist, but the most common is the 401(k). Since the creation of the 401(k) plan in 1978, it has become the most popular employer sponsored retirement account. It lets employees contribute a percentage of their wages into the account before taxes. The employer can also contribute to the account although it’s not required. Some employers use these plans as a method of distributing the company’s stock to employees. The employee pays taxes on the money at the time of distribution or withdrawal. Some 401(K)s allow additional contributions on an after-tax basis. When withdrawn or disbursed, these contributions are tax-free.
A 401(k) plan is a qualified IRA. This means that it falls under plans regulated by 1974’s Employee Retirement Income Security Act and the U.S. tax code. Money paid into an IRA doesn’t just sit there earning a small bit of interest as in a savings account. Normally, the employee gets to choose between a few mutual funds and the monies invested in that fund. Some plans also allow investment in stocks, bonds or other investment options. You’ll hear a 401(K) referred to as a defined-contribution plan. That means the account’s balance has two components: the employee and employer contributions and the investment performance.
An employee under 50 years of age can contribute $17,500 annually into their 401(K) account. The maximum employee/employer joint contribution is $51,000 annually. Employees 50 years of age and older may add $5,500 to that figure for a total annual contribution of $23,000. The maximum employee/employer joint contribution for this age group is $56,500. These limits do present a problem for those earning at the executive level. For example, an employee earning $750,000 annually must cap their contributions based on the first $255,000 of income. To allow higher earning employees to adequately contribute to their retirement plans, employers may also offer non-qualified plans. This can include deferred compensation plans or executive bonus plans.
Ideally, you won’t have to use the money in your 401(k) plan until retirement, but you can withdraw it if another trigger event occurs. The the employee’s death qualifies as a trigger, as does their suffering a disability or hardship (if the plan allows hardship withdrawals). If the employee separates from the employer or reaches the age of 59 and a half years, they may withdraw early. Finally, if the plan terminates withdrawals are allowed.
If you make a 401(k) withdrawal before you’re 59 and a half years old, you’ll pay a penalty. The distribution counts as ordinary income at tax time. You’ll also pay a 10 percent early distribution penalty. Every rule has its exceptions and you can avoid the distribution penalty if one of eight exceptions applies. The employee dies or becomes disabled. Another exception is if the employee withdraws after separating from the firm at age 55 or older. There’s no penalty as part of a divorce or domestic partnership settlement or if the employee’s deductible medical expenses exceed 7.5 percent of their adjusted gross income. Payments taken as a series of Substantially Equal Periodic Payments (SEPP) during the employee’s life or the lives of the employee and the beneficiary avoids penalty. If the withdrawal corrects an excess contribution or deferral or results from an IRS levy on the employee’s 401(k), there’s no penalty.
You must begin required minimum distributions (RMDs) at age 70 and one half unless still employed. Additionally, the plan must allow RMDs deferment until retirement.
The flexibility of 401(k) makes them popular for employers to offer as an alternative to the traditional pension fund, and an attractive choice for employees. Although the contribution caps can create an issue for higher income earners, the IRS allows numerous alternatives so employers can offer adequate retirement options to all employees.