Many employers offer eligible employees a 401(k) plan, which help workers prepare for their retirement. A 401 (k) plan refers to a type of “defined contribution plan that allows you to make steady contributions. The plan also permits your employer to contribute to your retirement account. When you retire, the amount of money accumulated in your account depends on the value of your contributions and rate of interest earned on investments in your account.
IRS rules also allow sole proprietors to set up 401(k) plans. However, you can only contribute for yourself and/or a spouse who works for you.
Basic 401 (k) plans have two attributes:
- Employee salary deferrals: Employees volunteer to contribute a percentage of their pre-tax earned income, which reduces the participant’s taxable income for the fiscal year. The IRS determines the maximum allowable contribution. For 2012, the IRS increased the contribution limit you can make to your account from $16,500 in 2011 to $17,000. Employers’ plans may restrict employees to a lesser amount.
- Employer match contributions: Employers match the employee’s contribution to the plan. The amount of the employer match depends on the plan’s design. The plan usually has a predetermined formula. For example, an average 401 (k) plan may offer a 50 percent match up to six percent of an employee’s salary.
Some employers add an optional feature to 401 (K) plans, which consist of “profit sharing.” A 401 (k) – Profit Sharing Plan provides eligible workers a third stream of contribution for their retirement accounts.
However, employers retain the right to make profit-sharing contributions at their discretion. Consequently, during lean economics times, some employers will cease profit sharing contributions.
If you would like to participate in your company’s 401 (k) plans, speak to someone in the human resources department. Most companies have a predetermine enrollment period once or twice a year.
Making 401 (k) Investments
Companies usually offer workers a variety of investment options for “asset allocation.” Plan participants can choose between stocks, bonds, and cash. This includes stock and bond funds. You can place your cash in a money market fund until you make a trade. Use an asset calculator to determine the best mix of assets for your personal circumstances. How you decide to allocate money for your retirement hinges on your risk for tolerance and when you plan to retire.
Regardless of how you invest your assets, depending on the rules of your plan you can buy and sell your assets without incurring capital gains taxes on the profits. However, expect to pay transactions fees for your trades. If you incur losses in your 401 (k) account, you cannot claim the amount you lose on your tax return.
Legal Access to Money in the Account
Vesting concerns your legal right to the contributions and profits in your 401 (k) account. Although Uncle Sam makes the rules for how vesting works, your employer chooses from among three vesting schedules:
1) Immediate – You have a legal right to all the money in the account.
2) Cliff – After you work a specified number of years—three years if you make contributions and five years if you don’t contribute, you automatically have a legal right to all the money in the account.
3) Graded – This vesting schedule allows you to gain access to the money in your account within increments. Your employer must allow you access to matched contributions over a two to six year period – starting with 20 percent in year two and 100 percent by year six. If the plan does not include matching funds, employers have a three to seven year period and must allow 20 percent access by year three of your tenure.
Your contributions and the interest earned on investments belong to you under all scenarios. You only have a right to your employer’s contributions according to the vesting schedule, which defines your legal rights under the plan.
Distributions, Taxes and Loans
According to the IRS, you/spouse can receive a distribution from your 401(k) plan in three ways:
1. Death, disability or leave employer.
2. Termination of the plan without your employer setting up a successor defined contribution plan.
3. Financial Hardship or you reached the required retirement age—currently 59 ½.
The IRS treats any distribution made to you before the legal retirement age of 59 ½ as part of your gross income. In addition, you may have to pay an additional tax (penalty) for early distribution. Your 401 (k) plan probably allows you to make “hardship withdraws” because of a financial emergency, such as risk of losing your home to foreclosure/eviction or funeral expenses for your spouse or dependent. You will only have access to your contributions to the account, which does not include any profits earned on your investments.
You must also include the money you receive in your gross income and may have to pay an additional tax.
Generally, you won’t have to pay taxes on the money in your 401 (k) account until you receive a withdrawal. If you start making withdrawals at age 59 ½, you will pay taxes on your contributions and profits in accordance with your tax bracket. Many 401 (k) plans permit you to withdraw loans from your account, which you must repay according to a set schedule. The IRS treats unpaid loan balances as a distribution, which makes you liable for taxes.