Make The Most Of Your 401(k)

Post on: 26 Май, 2015 No Comment

As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. That’s because 401(k) plans offer a variety of attractive features that make investing for the future easier and potentially profitable. Be sure to speak to your employer or plan administrator about the specific features and rules of your plan.

What Is A 401(k) Plan?

A 401(k) plan is an employee-funded retirement savings plan. It takes its name from the section of the Internal Revenue Code that created these plans. 401(k) plans are also known as qualified defined contribution retirement plans: qualified because they meet the tax law requirements for favorable tax treatment (described below); and defined contribution because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.

The Tax Treatment Of 401(k) Plans

The 401(k) plan allows you to contribute up to $17,500 of your salary in 2014 increasing to $18,000 in 2015 to a special account set up by your company.* Future contribution limits will be adjusted for inflation. In addition, individuals aged 50 and older who participate in a 401(k) plan can take advantage of catch up contributions, which permit an additional $5,500 in salary deferral contribution in 2014 and $6,000 in 2015.

Since 2006, 401(k) plans have come in two varieties: traditional and Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement or at age 59, at which point contributions and earnings are taxed as ordinary income unless rolled over to another qualified plan or IRA. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.

The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit, however, earnings on plan balances grow tax free ; you pay no taxes on qualified distributions.

Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after 59 (or age 55 if you separate from service from the employer whose plan the distributions are withdrawn from), although there are exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.

If your plan permits, you can make contributions in excess of the 2014 limit of $17,500 ($23,000 if over age 50), as long as your total contribution is not more than 100% of your pretax salary, or $51,000, whichever is less. That means if your salary is $100,000, you can contribute up to $50,000 total to your 401(k) plan during that year. In the case of a traditional 401(k), however, only the first $17,500 ($23,000 if over 50) of your contributions can be made pretax in 2014; contributions over and above that amount must be made after tax and do not reduce your salary for tax purposes.

*The maximum salary deferral amount that you can contribute in 2013 to a 401(k) is the lesser of 100% of pay or $17,500. However, some 401(k) plans may limit your contributions to a lesser amount, and in such cases, IRS rules may limit the contribution for highly compensated employees.

Matching Contributions

In addition to its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a traditional 401(k) plan, is taxable when withdrawn.

Employer contributions may require a vesting period before you have full claim to the money and their investment earnings. But keep in mind that if your company matches your contributions, it’s like getting extra money on top of your salary.

401(k) Advantages

Tax-deferred contributions and earnings on traditional plans.
Tax-free withdrawals for qualified distributions from Roth-style plans.
Choice among different asset classes and investment vehicles.
Potential for employer-matching contributions.
Ability to borrow from your plan under certain circumstances.

Tax-Deferred Compounding Potential: Time Is On Your Side

The benefit of compounding reveals itself in a tax-deferred account such as a 401(k) plan. As the chart on the previous page shows, if your $100 monthly contribution accumulates tax free over 30 years, assuming a hypothetical 8% rate of return, you could grow your retirement nest egg to $150,030. That’s a difference of almost $50,000 just because you didn’t have to pay current taxes up front!** Of course, you’ll have to pay taxes on earnings and your elective deferral contributions to a traditional 401(k) when you withdraw the money. But that may be when you are retired and possibly in a lower tax bracket.

**This example is hypothetical in nature and is not indicative of future performance, nor does it represent a specific product in your retirement plan. Withdrawals prior to age 59 may be subject to a 10% penalty tax.

You’re In Control: Choosing Investments Within Your Plan

Generally, 401(k) plans offer several options in which to invest your contributions. Such options generally include mutual funds that may invest in stocks for growth, bonds for income, or money market investments for protection of principal. This flexibility may allow you to help lower investment risk by diversifying your portfolio amongst different types of classes, manager styles, investment styles, and economic sectors.

What To Do When You Change Jobs

Most 401(k) plans permit the employee who terminates employment the options of receiving the 401(k) balance in a lump sum (which is subject to tax) or to receive periodic payments (which are subject to tax) or to roll over the proceeds to an IRA or other employer-sponsored retirement plan. Additionally, some 401(k) plans permit the terminated employee to retain their 401(k) balance in their former employer’s plan. Amounts that are retained in a a former employer’s 401(k) plan or transferred to another employer’s plan or IRA postpone the taxation until amounts are subsequently distributed from the plan or IRA the money was rolled into.

If you choose to receive the funds from your 401(k) with the intention to roll the amount to an IRA:

You must complete the rollover in 60 days.
Your employer must withhold 20% of the proceeds as a withholding tax. It is up to you to make up this 20%, or it will be treated as a distribution. The money withheld will be used as a credit against your income tax liability.
Neither the 60-day rule nor the 20% withholding apply to amounts directly transferred to an IRA or other qualified plan.

Borrowing From Your 401(k): Know The Rules

Another potential advantage of some 401(k) plans is that you may be able to borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you. However, borrowing from your 401(k) is generally not recommended since it reduces your investable assets.

There are some other issues to consider. If you leave the company, you may have to pay back the loan in full immediately (subject to the plan’s loan policy). In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.

Work With Your Financial And Tax Professionals

A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult your financial and tax professionals to help you determine how your employer’s 401(k) and other savings and investment plans could help make your financial future more secure.

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