A 401(k) plan is a retirement savings plan set up by an employer in which employees can choose to invest a portion of their wages for withdrawal in the future. These invested wages are referred to as “contributions”. The funds are not taxed until withdrawal, and the withdrawals are called “distributions”. As a benefit to an employee, an employer may also choose to deposit funds into the employee’s account, matching or adding to the employee’s contributions. The employer’s contributions are often tax deductible. (Another type of 401(k) is a Roth 401(k), in which contributions are made after-tax, though qualified withdrawals after retirement are free of federal income tax.)
In order to encourage employees to save for retirement, it is becoming more common for employers to automatically enroll new workers in a 401(k) plan upon hire. The employee can then choose to opt out later if he or she chooses not to participate. When you choose to participate in a 401(k) plan, you allocate a tax-deferred percentage of your salary to the 401(k) account every month. The amount you can contribute annually is indexed for inflation. In 2010, up to $16,500 can be contributed to the account and participants age 50 or older before the end of the tax year can contribute an additional $5,500. The funds in your 401(k) account will accumulate until you begin taking withdrawals in the form of retirement distributions.
Employer contributions are often subject to vesting requirements. “Vesting” is the right to ownership in the retirement plan. The money contributed by an employee to their 401(k) is always immediately vested, meaning the funds are the employee’s even if the employee leaves the employer. Employers, however, determine their own vesting schedules, and the portion contributed by the employer will usually be partially vested over time and fully vested after a specific number of years. The employee is only entitled to all employer contributions after being fully vested by meeting the employer’s requirements.
A 401(k) plan is portable.
When an employee retires or leaves a company, the employee can take the 401(k) plan in the form of withdrawing a taxable distribution or by moving the funds to another plan. Often, the funds in a 401(k) can be rolled over directly into a new employer’s retirement plan or into an individual retirement account (IRA) with no penalty. However, if an employee is not yet fully vested, some of the funds will not be available. The employee is only allowed to take the funds he or she is entitled to: the employee’s own contributions, any vested employer contributions and any earnings that have accumulated on those funds.
401(k) distributions are taxed as ordinary income. Federal income tax law requires that 401(k) holders begin taking minimum required distributions (MRDs) from 401(k) plans no later than April 1 of the year after turning age 70½. Except in special circumstances such as disability or death, funds withdrawn before age 59½ are subject to a 10% federal income tax penalty. As an alternative to withdrawing with the 10% penalty, some 401(k) plans offer loans, in which employees are allowed to borrow money from their 401(k) account (up to 50% of the account value or $50,000, whichever is less) with a five-year repayment period.
A 401(k) plan can be an excellent retirement savings tool, forming the basis of a strong retirement funding strategy. Even if you begin by only contributing a small percentage of your salary, it is a smart investment for your future. If a 401(k) plan is available and you are eligible to participate, you should participate, especially if your employer offers matching contributions.