401k FAQ
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VendorSeek
What is a 401k? A 401k is a savings plan for an employee's retirement. The employee authorizes pre-taxed pay to be put into the savings plan in the form of mutual funds or other options set up by the employer. The contributions and investment earnings have the ability to increase (tax-deferred) until they are withdrawn and then will be taxed as ordinary income.
How does it work? The 401k is established by individual employers. Though the employee is contributing to the funds, sometimes the employer's system involves 'matching' what the employees add or may contribute a portion (ex. $.50 to every $1.00 the employee puts in).
The 401k contribution is subtracted automatically from an employee's paycheck each period. It is taken out of the paycheck before taxes are imposed. The employee has the option of deciding how much money is taken out each period and how it will be invested. After those decisions are made, the rest is done automatically for the employee.
The money accumulates and is not to be taken out (though it can be, but you will be penalized) until retirement (usually the age of 591/2). The employee does not pay taxes while the money is accumulating, but once the money begins to be withdrawn, taxes will be applied to each withdrawal (small tax installments as opposed to a large sum).
What are the advantages? The money devoted to 401k is tax-deferred, so one does not pay taxes on the 401k contribution and pays less tax on the paycheck (that is minus the 401k contribution).
Employer contributions and growth of the savings is tax free until withdrawal.
If an employee switches jobs, their 401k savings are transferred to another business 401k plan
When a company matches or contributes it is like getting extra salary
What are the disadvantages? It is difficult or expensive (penalties) to access 401k money before retirement
Employer contributions do not become accessible to the employee until after a set number of years
The IRS sets a maximum contribution limit on 401k accounts
What are the investment options? There are a variety of different options available to employees. Mainly, the options take the form of several mutual funds. The funds include a money market, bond funds of different maturities, company stock, US savings bonds, along with others. Employees choose where to invest their savings and how future savings will be used. The employee can choose to devote funds to a specific area by time frame (bi-monthly, quarterly, etc.) and is typically allowed to stop contributions at any time.
How much can I contribute? The IRS set the contribution cap at $15,500 for 2007. The total amount contributed by employer and employee cannot exceed $45,000. If you will be the age of 50 or older by the end of the year, the contribution limits can be higher ($20,500 and $50,000). If you're a 'highly compensated' employee, then contributions can be restricted.
What constitutes a 'highly compensated' employee? In 2007, this means that you make over $100,000 a year. The IRS does not want the upper-tier employees to be contributing more than the lower-paid employees, so it is really a matter of what the whole of the business is doing. If a small percentage of employees that are lower-paid are not contributing much to the 401k plan, then the higher-paid employees will be restricted as to how much they can contribute.
If switching jobs, should I rollover my 401k or switch to an IRA? Some professionals say that the only reason you would want to roll into another 401k is if you want to take out of it early. IRAs give you more control of your assets. There are thousands of investment plans, but not even ten options for each 401k plan. Spreading out your assets is always a mantra of money professionals. It is suggested to put your money into a self-directed IRA and then try and contribute as much money as possible into the new job's 401k.
How long can a company hold onto contributions? The employer must deposit their contributions no later than 15 days after the end of each month. It could take as long as six weeks before money from your paycheck will show up in your 401k.
At what age can I take out of my 401k? The number seems to be 591/2 years of age without getting hit by the 10% early withdrawal fee. If one is at the age of 55 or older, and they have retired from their job, they can begin to tap into their 401k without incurring any penalties. This is deemed a 'separated from service' exception. It doesn't matter if you quit, leave, or are fired; you can even begin working somewhere else.
What are hardship withdrawals? Some companies will let the employee be able to permanently withdraw their money from their 401k. It is highly not recommended because you will have to pay income taxes on the money plus the ten percent penalty. Some reasons for early withdrawal are as follows:
To pay medical expenses
To pay college tuition
To cover funeral expenses
To avoid an eviction or foreclosure
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