|Retirement 401 K|
Retirement 401 k / 401(K) -
A 401(k) plan is a qualified defined contribution retirement plan that is employee-funded and company-sponsored. In some cases, employers can opt to match the employees' contribution. As a defined contribution plan, the amount the participant gets in retirement is based on the amount contributed to the plan and investment returns on those contributions.
The employer decides the eligibility requirements. Some companies allow immediate enrollment and some others make employees wait anywhere from three to 12 months.
Employees make periodic contributions from their paycheck before taxes (this is known as tax deferral). Any investment earnings or additional amounts matched by the company are also tax-deferred until retirement. The contribution or deferred limits of a 401(k) plan are currently $12,000 (although this amount changes from year to year) or up to 20-25% of the employee's pre-tax salary.
Some companies offer matching, in which they contribute an amount based on the amount you contribute (often 25%, 50% or even 100%). In such cases, it is best to contribute as much as possible. It's almost like free money. However, don't put too much of that money in the company's stock since you are already dependent on the company for your job and this compounds your risks.
A 401(k) should be considered as part of your overall investing strategy, therefore, since the plan is tax-deferred and the rest of your portfolio isn't, it makes sense to have tax-efficient investments outside the 401(k) plan.
Most plans have a defined list of investment options; most include mutual funds and individual stocks. Since this account is held until retirement, a more aggressive approach can be taken toward the 401(k) investments.
Investment options are limited by the employer. In order to minimize their administrative expenses, most companies allow only one fund family, and a couple of funds within the family. It is best not to contribute if there aren't any good investment options. Also, there are restrictions imposed on the types of investments 401(k) plans can include. Here are some of the allowed investments:
||Money market funds
||Debt free real estate
||Some insurance products like life insurance and annuity policies
||Bank deposit accounts or guaranteed investment contracts (GICs)
||Bond mutual funds
||Stock mutual funds
||Fees and Expenses
Participants may change their plan's asset allocation on a periodic basis; some plans will allow daily changes, others only every three months. All administrative costs, generally less than 0.5% of the assets, are charged to the participants. There are three categories of plan fees and expenses:
||Plan administration fees (including loads and commissions, management fees, and related fees)
||401(k) plan investment and services
In addition, there are three types of fees associated with plan administration:
||Sales charges (loads or commissions)
||Management fees charged by the broker
||Other fees, such as record keeping, furnishing statements, investment advice, etc.
If the employee leaves the company, he or she can choose to receive the total of the retirement account balance in cash; however, this will result in penalties and taxes; generally, there is a 10% penalty in addition to the applicable federal, state and local taxes. Here are some alternatives:
||Rollover the balance into another retirement plan within 60 days
The money is moved from the 401(k) account into another tax-deferred account; however, this must be done through a trustee or custodian.
||Keep the account with the employer
If the employer's plan offers good investment choices, the employee may decide to leave the account with the current employer. The account must have at least $5,000 and no additional contributions can be made to that account.
||Rollover the balance into a new employer's 401(k) plan within 60 days
If the new plan has better options and/or lower fees, consolidating all retirement accounts can simplify a participant's financial life. The same rules for IRA rollovers apply. The money can also be rolled over to an IRA while the new employer's 401(k) is ready.
||Early Withdrawals and Loans
A participant can take money out of a plan without a penalty in the following cases:
||termination of employment
||death or disability
||after age 59 1/2
In any other circumstances, withdrawals are subject to a 10% penalty.
Borrowing from a 401(k) is possible but it should be used as a last resort. Nonetheless, there are two methods in which you can use the money prior to the retirement age of 59 1/2 or any of the above mentioned circumstances: loans and withdrawals.
Loans may be taken out of a 401(k) depending on the employer's rules; if it is allowed, the amount a participant can borrow is up to 50% of the vested account balance with a minimum of $1,000 and a maximum of $50,000. The loan is paid back into the 401(k) account with interest through after-tax salary deductions. If the participant terminates employment at the company, the loan must be paid back in full with interest immediately.
||Withdrawals can be made if they qualify as hardship, only after the participant has placed a loan against the plan. According to IRS regulations, a hardship must represent "immediate and heavy financial need". Some of the reasons that qualify as hardship are buying a principal residence, paying college tuition, and paying for medical expenses that are not reimbursable. Withdrawals are subject to a 10% penalty in addition to taxes that apply.
Loans that are not paid in the designated period are considered withdrawals and therefore taxed as ordinary income in addition to the 10% penalty.
As a defined contribution retirement plan, a specific 401(k) will define the way a participant can take the money out after retirement. The options depend on each plan:
||Lump-sum payment: If the plan allows this type of payment, the following options are available. First, the participant can choose to take all the money in one payment and pay ordinary income taxes. Second, the participant can transfer the money into an IRA to preserve the tax deferral of those funds (only if the contributions were not made after taxes, in which case those will be paid out in a separate check), until withdrawals begin.
||Installment Payment: This option pays the market value of a fixed number of units held in the investment account each year. Taxes will depend on the period of time over which the participant chooses to receive the installments. If the period is 10 years or more, then each one will be taxed at ordinary income rates in the corresponding year. If the period is less than 10 years, the funds may be transferred to an IRA to continue the tax deferral.
||Annuities: If this is an option within the 401(k) plan, payments are transferred into an annuity and paid for life. Payments are taxed as ordinary income each time and are therefore ineligible for transfer to an IRA.
These choices all have significant tax consequences, although the rate might be lower at retirement.
Any of these distributions may include stock made as contributions by a company. It is up to the company to decide the value and to report it to the IRS when the stock is received as a distribution. As with any other shares of stock owned, taxes are not paid until the
stock is sold.
When opening a 401(k), the employee will designate a beneficiary, the person who will receive those assets after the employee's death. More than one beneficiary can be selected, in which case the amounts can be specified for each.
If there is no beneficiary or the beneficiary is a charity and the participant dies before the age of 70 1/2, the IRS will distribute the account over a five-year period to the estate or charity, respectively. If the participant dies after the age of 70 1/2, distributions of the account will be based on the remaining life expectancy based on the "Term Certain Method".
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