What is a 401k Retirement Plan?

(January 26th, 2008)

401k plan is a tax-deferred retirement savings plan that most large corporations and organizations have set up for their employees to help them save for their retirement. 401k plans originate from a family of defined contribution plans where both the employer and the employee pay a percentage of their pay to a savings plan. For example, if the employee saves 10% of his monthly gross income to a 401k savings plan, the employer might match this with a 5% contribution. Since both of these are "defined and fixed", they are known as "defined contribution plans." 401k derives its name from the Internal Revenue Code - section 401, paragraph (K).

How Do 401k Plans Work?

After 3-6 months of working for your current employer, you might be asked to join a company sponsored or administered 401k retirement plan. This plan works by you having to contribute a certain amount of money from your monthly pay before tax is deducted (your gross income). This amount is deducted even before you get paid, so there's an obvious advantage to it; you can never skip a savings contribution! On top of your contribution, your employer will "match your contributions" by a certain percentage. Most organizations match by 5-10%. The total contributions by you and your employer are then administered by a 401k plan administrator who invests this money in to mutual funds, stocks, bonds and other investments. It is up to you where you want to invest your money in. Your 401k plan administrator will give you a list of all investment vehicles available and their associated risk levels; you can clarify the risk taking level you are willing to take.
Note: Since a 401k plan is meant for you to save for your retirement, any withdrawals you make before the age of 59 and 1/2 are subject to a 10% early withdrawal penalty as well as tax payable on the withdrawn amount.

Advantages of Contributing Towards a 401k Plan

i) Your contributions are tax free from Federal & State taxes
ii) Your employer will match your contributions by a certain percentage, usually 5-10%, which is ofcourse extra money for you.
iii) Your employer also receives tax breaks by contributing towards your 401k
iv) A qualified 401k administrator invests your money wisely and in investment vehicles selected by you; thus your money is in good hands!
v) Any capital gains made on your 401k investments are also tax-deferred
vi) 401k loans and hardship withdrawals can be taken from your 401k plan under certain guidelines and regulations
vii) You will never miss a savings contribution because money is deducted from your pay before you even receive it!

How Much Money can you Contribute to a 401k Plan?

Contributions to a 401k plan can range from 1% - 20% of your annual salary. Annual 401k contribution limits are set by the Internal Revenue Service (IRS). For example, the maximum limit for 2007 contributions was $15,500. For a detailed list of 401k contribution limits for all years, visit maximum 401k contributions.

Can You Withdraw Money from a 401k Plan?

401k plans are designed to help you save for retirement. Therefore if you withdraw money from a 401k before the age of 59 and 1/2, you will be required to pay a 10% early withdrawal penalty, as well as taxes on the amount withdrawn. However, there are a few special cases where you are allowed to withdraw money from a 401k plan and not be penalized. They are:

i) 401k Loans - Some employers will allow you to take out a 401k loan from the total contributions you have made. Every employer sets rules for 401k loans, your best bet would be to talk to your Human Resources department. Go here for more information on 401k loans.

ii) 401k Hardship withdrawals - Some employers will allow you to take out a 401k hardship withdrawal if you are undergoing unfortunate events such as a large medical debt, illness or death of a related income earner. Be sure to ask your human resources department regarding company policy on this, because not all 401k plans allow 401k hardship withdrawals.

iii) Distribution upon Termination of Employment - If your employer terminates your employment, you are allowed to take a cash out distribution of all your 401k retirement savings. However, all these funds must be invested in another 401k retirement plan within 60 days, or else you will be charged a 10% early withdrawal penalty, and will have to withhold 20% of the amount for income taxes.

What Happens if I Change/Lose my Current Job?

You have three options if you leave your current job or get terminated:

i) You can keep your money in your former employer's 401k plan; you must have a fully vested amount of at least $5000 in order to do this. If you have savings of less than $5000 in your employer's 401k, they could force you to take a cash distribution. If you are concerned, talk to your HR representative regarding forced distributions.

ii) You can withdraw the money direct. If you are 59 and 1/2 years or older, you will be subject to normal income taxes, and no penalties. However if you are under 59 and 1/2 years, you will be subject to a 10% penalty as well as normal income taxes.

iii) You can transfer your 401k savings from your old employer to your new employer. Ask your HR representative for more information on how most efficiently this is done.