If you have spent two seconds reading about finance then you know that your 401(k) is a powerful money saving tool for your retirement. I doubt you'll find a single credible person who thinks that a 401(k) is a bad thing. Still, it is important to understand some basics in order to take full advantage of your 401(k) plan and maximize its value for your retirement planning.
What a 401(k) is
A 401(k) plan is simply a type of employer-sponsored savings plan which enjoys tax advantages due to section 401 sub-section K of the IRS code. That's where the name comes from. The special tax treatment allows the employee to make contributions to the plan with pre-tax monies which means that you do not pay taxes on the amounts you contribute to the 401(k) plan. So, if you make $50,000 per year and you put $5,000 per year into your 401(k) plan then you only have to pay taxes on $45,000 per year. This would be pretty powerful on its own, but there is another tax advantage. All taxes generated by your 401(k) account are tax-deferred, meaning you do not pay taxes on those events until later. So now, not only do you get the tax advantage of not paying taxes on the money you put into your 401(k), but you also don't have to pay any of the taxes along the way. Now, you can start to see some of the 401K plan's power.
Tax-Deferred is NOT Tax-Free
One of the biggest misconceptions surrounding 401K plans is that they are tax-free. They are not tax-free, they are tax-deferred. There is a big difference. Tax-free means you never pay taxes on the money. Tax-deferred means you pay taxes on the money later. When later? When you withdraw the money.
As you withdraw money from your 401(k) plan it is taxed as ordinary income, that is, like it was a paycheck. So, if you take $10,000 out of your 401(k), it is taxed just like you earned $10,000 at a job. This can make a very big difference in your retirement planning. For example, if you need $40,000 per year to live on during retirement, you will actually have to withdraw something closer to $50,000 per year. You will get to spend the $40,000 and the extra $10,000 goes to pay your taxes. Pulling $10,000 extra per year out of your account will make it smaller much faster, so it is important to plan for the effects of taxes on your 401K account.
59 1/2 the Magic Age for 401(k) Withdrawals
The 401(k) account is specifically designed for retirement, and only for retirement. It is not for remodeling the house, paying off debt, or sending the kids to college. To make sure 401K accounts are not abused, the IRS imposes a substantial penalty on 401(k) withdrawals made prior to the retirement age of 59 1/2.
Do you know why the age for retirement is 59 1/2?
The average age of the members of Congress was 59 1/2 when the age was set.
Any withdrawal made prior to the the participant having achieved the age of 59 1/2 is not only taxed as ordinary income (per above), but is also penalized by 10%. So that $25,000 that someone takes out to remodel the bathroom will have a $2,500 penalty, plus they'll have to pay regular taxes on the money. In the 25% tax bracket that works out to $6,250. So, that $25,000 withdrawal will cost you $9,000 in taxes! That means you net only $16,000. Now you can see why everyone says taking money from your 401(k) is a bad idea.
70 1/2 the Magic Age For Mandatory Withdrawals
One of the most misunderstood parts of 401k plans is the provision for mandatory withdrawals. Remember that 401k accounts are tax-deferred not tax-free. That means you have to pay taxes on the money someday. But the IRS isn't just going to sit around and wait for you to die. After all, the purpose of the account is to fund your retirement (so you don't notice how little money you are getting from Social Security) not to give you a place to stash untaxed money forever. So, starting in the year after the year in which you turn 70 1/2 you have to start taking a minimum amount of money out each year. This minimum amount is called the Required Minimum Distribution (money taken from a 401k account is called a "distribution".)
What makes it so confusing is understanding how much you have to take out each year as an RMD. RMDs are calculated by using a table. This table is a basic version of the tables insurance companies use to project life expectancy. A person's RMD is a percentage of the total 401(k) account value, based on how long they are expected to live. The longer the life expectancy, the smaller the required minimum withdrawal So, assuming your 401k account value never changed you would have to take a bigger RMD each year. But, in real life, your 401k account value will change so you could have to take a smaller RMD next year than you took this year if your account value goes down. (The required minimum withdrawal would still be a bigger percentage, but if the account value was low enough to offset this percentage increase, the RMD would still be lower.)
Don't even try to do the math. If you have a financial planner or financial advisor ask them to get you the numbers. If not, ask your CPA or accountant. There are also plenty of free calculators available on the Internet.
The key to calculating RMDs is to know that it is based on the end of year value from the previous year. So, to calculate a required minimum distribution for 2015, you use the account value from December 31, 2014.
401(k) Loans and Other Fancy Stuff
Don't do it. There that was easy.
401k loans cause plenty of heartache for people each year. Read the 401(k) loan article here, for all the gory details. The biggest gotcha is that most 401k loans have to be repaid right away if you quit or get fired and that can be a big headache for most people. It also diminishes your 401k account return, and it is plenty hard enough to save for retirement already without hurting your returns.
If you are under 59 1/2 DO NOT even think of getting a debit card or other way to access your money. The 10% penalty will kill you. Even if you are 59 1/2, do not take withdrawals from your 401(k) until you actually retire. Just because you can take the money doesn't mean it is a good idea.
Knowing about 401(k) rollovers is helpful too.
Who Gets a 401(k)
401ks are employer-sponsored retirement plans. That means that an employer can (but does not have to) offer a 401(k). There is no 401(k) plan without an employer. (There is an Individual 401(k) plan, but that requires you to be a business owner which, technically, makes you the employer of yourself.)
You employer may match contributions to a 401(k) plan. Doing so gives the employer a tax benefit and also is a benefit that can be used to attract and retain good employees. Any match must be the same for all employees within certain guidelines, although there are certain allowable eligibility requirements. The most common eligibility requirement for participating in a 401(k) plan is minimum employment, usually 1 year.
Matching is typically done via a percentage, and there are many formulas. Most common is a 50% match. If you have better matching your plan is above average if you have lesser matching your plan is below average.
Because the 401k plan is supposed to be a long-term retirement account your employer may have a vesting schedule. Vesting simply means how fast the money becomes your money.
Any Amount of Money You Put from Your Paycheck Into a 401(k) Plan is 100% Your Money (100% Vested) from Day 1. There is No Vesting Schedule for Your Own Money.
Confusion regarding their own contributions is one reason some people don't participate in 401(k) plans because they mistakenly think that they have to wait to get their own money. In any 401k plan only the employer contribution vests. Since you will get 0% of that money if you don't participate, it is still better to participate in your 401k plan and get 20% than to not participate and get 0%
The most common vesting schedule is:
20% First Year
40% Second Year
60% Third Year
80% Fourth Year
100% Fifth Year
In other words if you quit after being employed three years, you will get to take with you 60% of the employer match and 100% of your contributions.