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401Kafe
General -
Frequently Asked Questions |
What is
a 401(k) plan?
A 401(k) plan is a
retirement plan set up by your employer. It is a simple and convenient way for you to
build up your retirement savings and get significant tax benefits while you are working.
It is named after the part of the IRS Internal Revenue Code that spells out the rules for
this type of plan: Section 401, paragraph (k).
When you join a 401(k), you agree to contribute part of your salary to the 401(k) account.
The money you contribute is deducted from your paycheck before income taxes are taken out,
so you end up paying less income tax. Additionally, you don't pay taxes on what you
contribute (and any interest it earns) until you withdraw money from your account at
retirement . This way, you enjoy the benefit of tax-deferred compounding, which helps your
savings add up quickly!
Of course, there is a catch. (There always is, when it comes to tax advantages.) You
cannot withdraw money from the account before you turn 59 ½ – except in rare cases
– without paying a stiff penalty.
The 401(k) account is not an investment in itself; it is a protective shell for your
money. It is up to you to decide how to invest the money using the choices your employer
provides for you. Generally, these are stock, bond and money market mutual funds.
Some employers offer a match, meaning that for every dollar you contribute up to a certain
amount, your employer will also make a contribution (10 cents, 50 cents, a dollar –
it depends on your employer). As free money, this is worth taking advantage of.
Each company's 401(k) plan has different rules. The best source of information about your
particular plan is the "Summary Plan Description," which you can get from your
company's human resources or benefits representative.
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Why do
I need a 401(k) plan?
Your 401(k) plan helps you start regular investing, and stick with it. Your contributions
are automatically deducted from your salary before you receive your check. Since the money
is deducted from your gross income, you will have a lower taxable income, which means you
will pay less in annual taxes.
The money you save will accumulate on a tax-deferred basis. This means you pay no federal
or state taxes on your contributions or investment earnings until you start withdrawing
money from the plan. The benefit of a tax-deferred account is that your dollars accumulate
more quickly because the interest you earn each year is not taxed.
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What
happens to my 401(k) plan if I switch jobs?
A. If your vested account balance is $5,000 or more, you can leave your money where it is
– and taxes won't be due until you withdraw money from the plan.
B. You can roll over your 401(k) into a rollover IRA account or into your new employer's
401(k) plan. If you do a direct rollover – have the money transferred directly into
the new account – you won't owe taxes until you withdraw money from the account.
C. If you elect to take your money out of the 401(k) and not roll it over into a rollover
IRA or another 401(k) plan – you will owe all applicable taxes, plus, if you are
under 59 1/2, you will have to pay a 10% early withdrawal penalty. If you are at least 55
years old and you quit your job or are fired, and you don't go to a new job, you won't
have to pay the 10% penalty either.
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What
is the maximum I can contribute to my 401(k)?
Because Uncle Sam loses tax revenue for every dollar you contribute to your 401(k), the
IRS imposes a maximum pre-tax contribution limit. The limit is periodically adjusted for
inflation.
For 1999, the maximum pre-tax contribution a participant can make to a 401(k) plan is
$10,000, which is unchanged from 1998. Any matching contributions by your employer are not
included in this limit.
The amount of your contribution is, however, subject to the 25% of pay limitation and
special non-discrimination tests as described below.
The percentage of pay limit says that the maximum amount that can be accumulated in any of
your tax-qualified defined contribution plans – not just your 401(k), but also
thrift, profit-sharing, ESOP and money purchase – is 25% of your gross income or
$30,000, whichever is less. Every dollar contributed (both employee and employer) counts
toward this limit.
Finally, Congress and the IRS have established non-discrimination rules to prevent highly
compensated employees from being able to save substantially more than lower paid
employees. If you earn $80,000 per year or more, or own 5% or more of the company,
additional contribution caps may apply.
In addition to the pre-tax contributions described above, some plans also allow
participants to make after-tax contributions that aren't included in the government limit.
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What
is the penalty if I take money out of my 401(k) before I’m 59 1/2?
The penalty is 10% of the
untaxed money you withdraw, plus applicable federal, state and local taxes on that amount.
So if you were to withdraw $5,000 from your 401(k) before age 59 ½, you would owe a
penalty of $500 (plus applicable federal, state and local taxes on the entire $5,000).
You may not have to pay the 10% penalty, depending on the rules of your 401(k) plan, in
the following circumstances:
A. If you become totally disabled.
B. If you die, and your beneficiary collects the money.
C. If you are in debt for
medical expenses that exceed 7.5% of your adjusted gross income.
D. If you are required by court order to give the money to your divorced spouse, a child,
or a dependent.
E. If you are separated from service (through permanent layoff, termination, quitting or
taking early retirement) and you're at least 55 years old.
F. If you are separated from service and you have set up a payment schedule to withdraw
money in substantially equal amounts over the course of your life expectancy. (Once you
begin taking this kind of distribution you are required to continue for 5 years or until
you reach age 59 ½, whichever is longer.)
Any money withdrawn for the above reasons would still be subject to applicable federal,
state and local income taxes.
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Can
I roll over the 401(k) money from my old job into my new company’s plan?
Yes, if your new company's plan allows rollovers. If you roll over your 401(k) money into
your new company’s 401(k) plan, you maintain the account's tax-deferred status and
will not have to pay taxes on the account until you withdraw money from the plan.
If your new company does not allow rollovers, you have two other options that would allow
you to maintain the account's tax-deferred status.
A. If your vested account balance is $5,000 or more and you're under age 65, you can leave
your money in your old employer’s 401(k) plan – and taxes won't be due until you
withdraw money from the plan.
B. You can roll over your 401(k) into a rollover IRA account. If you do a direct rollover
– have the money transferred directly into the new account – you won't owe taxes
until you withdraw money from the account.
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