401(k) Explained

By Chelle Cordero

December 27, 2016 5 min read

Saving toward retirement got easier in the early 1980s when employer-sponsored 401(k) retirement plans allowed tax-deferred funds to be set aside for an employee's retirement. Social Security is rarely enough for seniors to exist on in retirement. A 401(k) can add vital additional income.

Based on a 1978 Internal Revenue Code, a 401(k) allows a portion of earnings to be put in a special account. Sometimes employers will match the amount of the employee's contribution. Employers who sponsor 401(k) retirement plans can benefit taxwise by contributing to an employee's plan within set guidelines. For instance, an employee must be fully vested for a minimum time period of employment before being entitled to any employer-supplied funds in the account.

There are various forms of retirement savings plans (traditional 401(k) plans, safe harbor 401(k) plans and SIMPLE 401(k) plans), an employer's funds manager needs to make sure that each plan is in accordance with the specific rules in order to keep the tax-advantage. The general rules allow for payments from the retirement account to begin at the government recognized retirement age, but payments must begin no later than 70 1/2 years of age.

Most 401(k) employee contributions are made from pre-taxed income which can substantially lower the yearly taxable income level; the Roth 401(k) donations are made after total income is taxed. When contributions are made from pretax income, taxes will have to be paid at the time of withdrawal at the current rate; however, the retiree's income is usually lower than during the work years and can translate to a lower tax rate overall (tax rates may change in future years). Employees are not required to participate and contribute to a 401(k) plan, but it is a terrific opportunity to set aside money toward a substantial savings account.

The 401(k) plans grow from a combination of employee donations, employer-matched funds and compounded interest. Plan managers are professional investors who are used to market fluctuations and can invest your money in the market leaving you with a professionally managed and diversified portfolio. Most mutual fund plans cost a minimum to buy into, but with a 401(k), your predetermined contribution is made from each paycheck and builds each pay period. Employees can choose a set amount of contribution or a specific percentage of the wages earned. An investment in a 401(k) retirement savings plan is painless and automatic since the funds are deposited before you see them in your paycheck.

Withdrawing funds before the recognized time could be subject to income tax and a 10-percent penalty. Although, depending on the specific plan and circumstances, exemptions for non-penalty withdrawals may be allowed for medical expenses, financial hardships, divorce, college tuition or death of the employee. An individual seeking an exemption needs to talk with the plan administrator about the plan's provisions.

If the employee changes jobs, the funds can be withdrawn without penalty, as long as they are reinvested in another recognized retirement account no longer than 60 days; if the new investment isn't made within those 60 days, both penalty and income tax will be applied. If your new employer doesn't sponsor a retirement plan, you can roll your 401(k) funds over into an Individual Retirement Account. There are several different types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs and SIMPLE IRAs; each one has certain eligibility guidelines so speak with an investment counselor to make sure you are choosing the right plan for your needs.

There are also instances where an employee can borrow against the balance in his retirement account and repay the amount with finance charges that may be credited as additional contributions to the fund balance. Depending on the plan's requirements, taxes may be imposed on the amount borrowed. Loans and early withdrawal exemptions may apply to IRAs similar to those that apply to employer-sponsored plans.

According to the United States Department of Labor, the majority of Americans spend at least 20 years in retirement. If your employer offers a 401(k) plan or if you are self-employed and need an IRA, those funds can help ensure a fiscally safe future.

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