401(k) Basics
About two-thirds of American workers have access to a 401(k) plan, so there’s a good chance you’ve heard of it. As pensions fade away and the long term viability of Social Security seems less and less stable, people have to depend on 401(k)’s to carry more of the burden of their retirement needs. This is a basic review of how 401(k)’s work and what some of the common terms mean.
What is a 401(k)?
Many people believe a 401(k) is a type of investment. That’s not exactly right. A 401(k) is a type of savings account set up by your employer that receives special tax benefits based on section “401”, subsection “k” of the US tax code. Within the 401(k) account you can invest your savings in several different options. You can contribute your own money to the account and many times, your employer will contribute additional funds on your behalf.
What are the tax benefits?
The 401(k) allows you to set aside some of your earnings and not report them on this year’s tax return. Effectively anything to put into your 401(k) is like subtracting that amount from what you need to pay taxes on. Additionally, once you have directed money into your 401(k), you can start investing it. As those investments grow, you don’t need to report those earnings on your taxes each year either.
How does matching work?
Employers have the option to add additional funds into your 401(k) on your behalf. This is most frequently done by employers matching the contributions you make on your own. There are two matching percentages to understand. 1) The percent of your income. 2) The percent of the match. Most 401(k)’s that offer matching will match a stated percentage of your contribution up to a percentage of you income. For example, your employer may match 50% of your contributions, up to 5% of your income. So a person who earned $100,000/year(just to make the math clear) could contribute 5% of their income or $5,000 from their pay. The company would then match 50% of that 5% contribution and add an additional $2,500. The employee would then have $7,500 in their 401(k) after only setting aside $5,000 of their own money(not bad). Now if the employee contributed 10%($10,000) of their income to the 401(k), how much would the match be? It would still be $2,500 because the company only matches the first 5% of employee income.
The most common matching plan for employers is to match 100% of the employee’s first 3% of income and then match 50% of contributions from 3-5% of income. Some employers will require the matching contributions to be returned to the company if you do not remain employed by them for a certain number of years.
What can I invest in?
Under Federal law, all 401(k)’s must offer a “broad range of investment alternatives.” This means you will typically be able to invest your savings in a variety of different areas. You should be able to find choices to invest in large more stable companies, smaller companies with more potential for growth, foreign companies, corporate bonds, government bonds, and a money market fund(which provides security and returns similar to a savings account). Most public companies will allow employees to invest in the company’s stock within the 401(k), but for the most part, 401(k) investments are limited to mutual funds. The majority of 401(k)’s offer a fraction of the investment options you would have access to investing in an Individual Retirement Account(IRA), but you will still find enough options to compile an effective portfolio. A few 401(k) plans today allow participants access to a full self-directed brokerage within their 401(k) allowing them to invest in nearly any stock or bond in the market, but that’s not necessarily a good thing.
What’s the downside?
The benefits of a 401(k) are great, but in order to receive those benefits, you’ll have to accept some restrictions. Once you’ve contributed to a 401(k), getting the money back out will come at a price. If you are under age 59 1/2 when you withdraw 401(k) assets, you will face a 10% federal tax penalty, plus a 2.5% California tax penalty. So pulling out $10,000 will cost you $1,250 in penalties. Additionally, anything you withdraw from your 401(k) will be added to your taxable income for the year and be taxed at your highest personal rate. For most people, pulling out money from their 401(k) before age 59 1/2 could mean they lose about half of the money they withdraw to the government. If you are in a true emergency and desperately need your 401(k) money before 59 1/2, consider taking a 401(k) loan instead of a withdrawal. 401(k) loans have their own downsides, but can potentially save you from major taxes and penalties.
You have to pay taxes on the money when you take it out no matter what age you are. So try to plan to withdraw the money when your income is less and you are in the lowest tax bracket possible. You can’t wait forever though. The IRS requires you to start withdrawing at age 70 1/2. They gotta start collecting your taxes on that money at some point right?
Recent Comments