401k Planning Definition
The most common and popular type of defined contribution retirement savings account is the 401k, or 401(k). The 401k provision in the tax code allows workers to avoid paying income taxes on the portion of their income which is elected to be moved directly into a 401k account. This retirement plan type allows workers to inject tax free dollars into an environment in which it can grow tax free until withdrawals are made at retirement.
Each 401k plan has a list of investment options available, which is set at the company level. These investment options tend to find top performing, stable funds that will appreciate steadily over time. They include investment options through the form of mutual funds consisting of stocks, bonds, and commodities to name a few. Check with your plan sponsor or administrator for more information.
The 401k plan allows an employee to take up to 15% of their income, capped at $16,500 per year and inject it into the 401k account. If you move from one job to another, you may elect to rollover your 401k from your former employer to your new one. This will simplify your life by limiting the number of accounts that you will have to manage.
Employee contributions will vest immediately so there will be no need to worry about getting your money out if you decide to leave the company.
Employees over the age of 50 should also understand that they are eligible to make "catch-up" contributions when they reach this age. This means that employees are eligible to contribute another $5,500 (as of 2010) into their 401k account at a tax free rate. This catch up amount will be adjusted over time with inflation so it will only increase as time passes.
While it is not mandatory for your employer to contribute to your 401k plan, most will contribute in some fashion. Employers may choose to contribute by depositing a fixed amount into each employee's account every year, such as $2,000.
Another popular method of contribution is through profit sharing contributions which will inject a certain percentage of your salary into your account every year, regardless of whether you contribute or not.
Finally, an employer may participate in a matching contribution which matches the employee's contribution by a certain percentage, such as 3%. This percentage is based on the salary and not the actual contribution you make. For example, if you earn $100,000 and contribute $15,000, your employer would contribute an extra $3,000. As you can see, the more you contribute, the more your employer will as well.
Most employers vest the match amounts over a certain number of years in an effort to retain their employee's.
The purpose of the 401k plan is to provide workers with a vehicle to save for retirement; therefore, the IRS tax code specifies a penalty of 10% on top of federal taxes that will be withheld if an early withdrawal is made. An early withdrawal is defined as someone who is less than the age of 59 and a half. For those of you who are above 59 and a half, withdrawals can be made at your current tax rate.There are a few caveats however, if you are between 55 and 59.5 and disabled, you can avoid the early withdrawal penalty. Secondly, the IRS permits a hardship withdrawal for specific reasons such as avoiding foreclosure or eviction, buying a new home, help paying for medical expenses, paying college tuition, certain expenses related to the repair of a primary residence, and paying for funeral expenses of a family member. Taking a hardship withdrawal will put your contribution schedule on hold for 6 months.
The Bottom Line
The bottom line on a 401k plan is that is is nearly essential for everyone to participate in it. Between the tax advantages and the employer match, your investment nearly nearly goes up by 50% instantly. For example, assume you plan on contributing $16,500 to your 401k account with a 3% employer match. Essentially, you will be saving $19,800 at a tax free rate.
Now, let's turn to the equivalent if you actually took it in cash in your paycheck. Assuming a 25% tax bracket, you would be receiving nearly $12,400 out of that $16,500. If this isn't a no brainer, the longer term tax free compounding is. You will essentially be compounding your contributions over many years at a tax free rate. This translates into massive amounts of savings when retirement comes around.
It would be wise to contribute as much as you can to a 401k account if you not already doing it. The best advice I can give is to START EARLY. Start in your 20's and you will be a millionaire by the time you retire.