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9 THINGS YOU NEED TO KNOW ABOUT A 401(K) PLAN
Are you thinking about investing in a 401(k) plan? Investing your money can be a really scary topic. Some people have lost money doing it while others have made a fortune. Regardless of your past experiences with investments you still need to know the types of investments you can make. With a 401(k) you will find pros and cons just like any other investment opportunity. Do you know enough about a 401(k) plan to invest in it?
I’m sure you’ve heard it mentioned before. You’ve probably seen some paperwork from your employer about it. Have you taken the time to actually research it and learn about the plan offered to you though? If you answered no to that last question then you will really want to make sure you continue reading.
You could be leaving FREE money on the table for no reason. Not only that, but if you are ignoring your 401(k) plan then you’re doing more than leaving money on the table. Ignoring your 401(k) means you may be ignoring your future retirement. If you haven’t guessed already, a 401(k) is an investment for your retirement, kind of like the social security benefits you hope to receive one day.
1. What is a 401(k) Plan?
A 401(k) is a retirement savings plan that some employers offer. A traditional 401(k) plan is deposited into an account pre-tax. This means that you don’t pay taxes on the money you put into your 401(k) in the year you earn it. This can help lower your taxable income for the year. An example of this is if you made $65,000 in the year 2016 and $5,000 of it was placed into a traditional 401(k), you would only pay taxes on $60,000 that year.
Before you go getting too excited, this doesn’t mean you wont be paying taxes on that money. You should already know the government will always want to make sure they get their piece of the pie. Instead of paying the taxes on the money you put into it that year, you will pay your income taxes on the money when you withdraw it later on down the road, preferable when you’re retired.
2. Do I NEED a 401(k) Plan?
The simple answer to this is “no”. You don’t NEED to have a 401(k) plan in place. There are several reasons why you may not want to or can’t have a 401(k) plan. One reason is you simply may not be able to afford to contribute to a retirement plan at the moment. I know it’s hard to believe but not everyone has extra income they can spare for a retirement fund. Although even $5 dollars into a 401(k) is better than nothing.
More Reasons You Don’t Need a 401(k) Plan
You may not need a 401(k) plan because your employer doesn’t match your contribution.This is a perk that some employers offer and a topic I go into a little more, further down in the article. If you work at a place where the employer doesn’t contribute, you may be able to find a better way to invest your money and receive higher returns.
Also, You may not want to invest in a pre-taxed 401(k) plan because you fear a future tax increase. This fear is somewhat justified due to my nations (The United States) previous tax rates. The max tax rate in America has been, in the past, higher than it is today. For example from 1940-1960 everyone in the top American tax bracket was taxed at rates of 80%! That’s more than double the top tax bracket rate of 39.6% we see today. Personally I don’t believe we will see taxes that high again but it isn’t impossible!
I would be lying if I said that there weren’t better investment options, some more riskier than others. 401(k) plans are a safe and secure option for anyone trying to help save up for their retirement. It isn’t a MUST HAVE kind of plan but it truly is a plan worth looking at.
3. Why Should I Invest in a 401(k) Plan?
Alright, so now that I’ve made investing and taxes even more scarier than they already are, here are some reasons why you SHOULD invest in a 401(k) plan. For starters, I mentioned the employer contribution to your plan. If you find yourself at a job where the employer does contribute to your plan, it can be worth adding a little extra money into it. You’ll still have to keep reading to figure out what this contribution looks like!
Aside from being given free money by your employer, you could also help reduce your taxable income for the year. As I mentioned earlier, whatever amount you contribute, to a pre-taxed 401(k) plan, you don’t pay taxes on for that year. This can be extremely helpful for the people who are right on the line of a different tax bracket. Below is the 2016 tax bracket for the United States.
Here is a perfect example of how contributing to a pre-taxed 401(k) plan will help you. If your taxable income was $40,000 for the 2016 tax year, you would have to pay $5,183.75 plus 25% of the amount over $37,650 for your taxes. Which would mean you’ll pay 25% of $2,350 for a grand total of $5,771.25 in taxes for the year 2016. All because you earned an extra $2,350. If you would have contributed $2,400 to a pre-taxed 401(k) plan, your taxable income would have been $37,600. Which means you would have been taxed in the lower bracket. So you would have paid $927.50 plus 15% of the amount earned over $9,275 for a grand total of $5,176.25 in taxes for the year 2016. By adding $2,400 to your retirement in the year 2016, you prevented yourself from having to pay $595 extra in taxes.
How a 401(k) Plan is a “Safe Option”
Another great thing about a 401(k) plan is that it is a safe option. What could I possibly mean “it is a safe option”?? Well, lets say you manage to put yourself in so much debt that you have to file for bankruptcy. The banks are going to try and get every penny they can out of you. They will take money from your checking account, savings account, and your investment accounts. You could lose your house, your car, or anything else that you own with any kind of value. One thing the banks CANNOT touch at all, not one single penny, is a 401(k) plan.
As long as the money is located in your 401(k) plan when you file the paperwork for bankruptcy, it will come out untouched. A side note with this, if you do need to file for bankruptcy and you want to withdraw your 401(k) plan to help cover expenses, speak to your lawyer! You DO NOT want to withdraw this money prior to filing if you can help it. As soon as you withdraw the money, it can, and more than likely will, be included with the bankruptcy.
4. What is an Employer Contribution?
So, I promised you earlier I would elaborate on the employer contribution, and here it is! For the most part, an employer’s contribution is pretty self-explanatory. An employer has the option to contribute to your 401(k) plan in two different ways. The first is where your employer makes a contribution on your behalf. The second is where they contribute an amount equal to what you add to your 401(k). So if you add $100 into your 401(k) plan every pay check, your employer will do the same. That’s a 100% return on investment, IMMEDIATELY! I don’t know about you but you wont find that kind of return placing money into a savings account. Some employers decide to use both options to help contribute to their employees 401(k) plans.
Obviously this sounds too good to be true! It really isn’t but, like most good things, there is a downside. Employers who do this, as a benefit to offer their employees, have a cutoff for the amount they are willing to match. This amount can vary from employer to employer, but regardless of what the employers contribution cutoff is, their is a limit set by an IRS tax code. The max limit for the combined employee AND employer contribution is quoted below and set by the IRS tax code.
The lesser of 100% of an employee’s compensation or $54,000 for 2017 ($53,000 for 2015 and 2016 not including “catch-up” elective deferrals of $6,000 in 2015 – 2017 for employees age 50 or older) (IRC section 415(c))
Rules Your Employer Places on Your 401(k) Plan
Employers offer many varieties of benefits to their employees. This just so happens to be one of the many. They don’t just give this one out freely though, uh-oh here comes another downside. When you’re dealing with an employer contribution to your 401(k) plan, your employer has rules in place. Some of these rules include the max amount they are willing to contribute, but all employers have one thing in common when it comes to a contribution like this. Every employer requires you to be 100% vested to received 100% of their contribution. No it has nothing to do with clothing but if you want to know more about it, you’ll just have to keep on reading. Yea yea yea, I’ve been making you wait a lot, you’ll be okay. 😉
5. What Does it Mean to be “Vested”?
See, you didn’t have to wait that long this time to learn the meaning of being vested. Merriam-Webster defines “vested” as fully and unconditionally guaranteed as a legal right, benefit, or privilege. This hits the nail on the head for the definition per your employers but what does that mean for you and your free money?
This means, for most employers, that you have to pay your dues before you can claim full possession of that extra money. Some employers allow you to be 100% vested immediately upon employment. The majority though, require you to have worked at the company for a certain period of time. This is the part that varies from employer to employer. Depending on your employers plan, you may be required to work at your job for 3 years, 4 years, 5 years, or whatever time frame they set to become fully vested (receive 100% of the employer contribution). Your employer may allow you to gradually become vested overtime by a certain percentage each year or all at once upon the completion of the required employment years.
How You Might Lose Some or Even All of Your Employer’s Contribution
If you leave your employment, by your own choice or by termination, before you are fully vested, you could lose some or even all of the money your employer contributed. If you become fully vested at 5 years and you’re in your 4th year with the company, it would be wise to stay with the company until your 5th year so that you do not miss out on the free money that was offered to you. Obviously if you don’t have a choice but to leave, then do what you have to do, but if you can help it, try to stay until you are 100% vested before making the decision to leave.
6. How do Taxes Work with a 401(k)?
I mentioned earlier, that you do not have to pay taxes on a traditional 401(k) plan in the year you make the contribution. The exception to this is if you withdraw from your 401(k) that year. This doesn’t mean you’ll receive the money tax free when you do finally withdraw it! Instead, you’ll pay the taxes on it later when you do pull it out.
Whenever you go to make a withdraw from your 401(k), it will be taxed as regular income and the rate will reflect as such, depending on the amount you withdraw. This could be lower or higher than the tax rate was when you originally added the money to your plan. As you withdraw from your 401(k) you will be taxed on it exactly as you would be if it was a paycheck you got from work. So if you’re withdrawing at an amount to put you in a higher tax bracket then you were when you collected a check, expect to see more taxes taken out.
How To Get Taxed Less on Your 401(k) Plan
If you would like to lower the rate at which you are taxed at, all you will have to do is lower the amount of money you receive each year. The more you earn, the more you’ll have to pay in taxes. If you are right on the line of one of the tax brackets, I listed above, you may consider trying to cut out some spending habits to help lower your taxes for the year. Getting taxed less on your 401(k) plan will also help extend the use of the money you saved for retirement. This can be very important because YOU’RE RETIRED! Extending the life of your retirement funds helps ensure you don’t have to go back to work when your 80.
7. What Happens to my 401(k) if I Leave My Job?
When you leave your job, you don’t lose your money. You may lose some or all of your employer contributions though. This will depend on how vested you are with your company. It doesn’t matter if you resign or get terminated, you will still own the money you put into your 401(k).
You do however have to make a decision on what happens with that money. Depending on your employer they may allow you to continue to have the 401(k) with them. You just won’t be able to add to it anymore. More than likely you wont be leaving your money in the hands of your old employer though. You’ll want to look into all of the options available to you when you leave. This may include speaking with a financial adviser to help you make the best choice for you.
Where Can You Move Your Money?
Another option you have is to rollover your 401(k). This is a term used to describe transferring your tax-protected retirement savings from one account to another without paying an early withdraw fee. I’ll explain this fee a little later in the article. (You know I’m good for it!) This could be from one employer’s 401(k) plan to another. You can also transfer your 401(k) to an IRA (Individual Retirement Account) if your new employer doesn’t offer a 401(k) plan.
The other option you could go with is to withdraw all the funds that are in your 401(k) account and place it into your own account. I will have to say, in my opinion, this is the worst of the choices but it is an option. An option you may have to go with depending on your reasons for leaving, and your financial situation at the time. The reason this one is viewed as the worst will be explained in the coming section, along with the information about the fees I mentioned! I think you may already see where that explanation is going to go.
8. When Can I Withdraw From my 401(k)?
Technically the answer to this question is whenever you want. Though you may want to hold off on getting that check sent to you. If you make the decision to withdraw from your 401(k) plan prior to turning 59½ then you may receive a 10% penalty. This penalty will be on top of the federal and state income taxes you will have to pay for the money received that year.
After you turn 59½ you can withdraw from your 401(k) without the 10% penalty being added. You can receive the payout in many different ways. Such as taking a lump-some of the full amount. This isn’t always the best way though because of the income taxes you will have to pay on this withdraw.
You may decide it would be more beneficial to receive a portion of it every couple weeks, once a month, once a quarter, or once a year. The ability to change the plan, to your preference, throughout the year will also be available to you. Just be sure you speak with a financial advisor to help you make some of these decisions.
More Ways to Withdraw from a 401(k) Plan, without a penalty!
There are a few other ways that you could look to withdraw money from your 401(k) without receiving the penalty. One of those ways would be borrowing funds. Your plan must offer an option to do a loan this for it be a possibility though. If you aren’t able to repay the loan, it would act as a distribution and be subject to taxes and penalties.
You can also withdraw money from your 401(k) plan due to a hardship. This doesn’t have to be an involuntary hardship or an unforeseeable hardship either. Keep in mind though, it isn’t considered a hardship if the employee holding the 401(k) plan has other means to satisfy the immediate or heavy financial need. The IRS explains what is required for a distribution from a 401(k) plan, below.
For a distribution from a 401(k) plan to be on account of hardship, it must be made on account of an immediate and heavy financial need of the employee and the amount must be necessary to satisfy the financial need. The need of the employee includes the need of the employee’s spouse or dependent. (Reg. §1.401(k)-1(d)(3)(i))
This second quote, also from the IRS, gives examples of the types of hardships that may allow you to do an early withdraw from your 401(k) plan without receiving the 10% penalty normally applied to an early withdraw. Regardless of how the IRS defines a hardship, the 401(k) plan your employer has in place, may be a little more strict on what qualifies as a hardship so be sure to look into that when you’re thinking of setting up a plan. When you take money out of your 401(k) plan to satisfy a hardship, you will not be able to contribute back to it for 6 months. This also applies to any other plan maintained by your employer.
Whether a need is immediate and heavy depends on the facts and circumstances. Certain expenses are deemed to be immediate and heavy, including: (1) certain medical expenses; (2) costs relating to the purchase of a principal residence; (3) tuition and related educational fees and expenses; (4) payments necessary to prevent eviction from, or foreclosure on, a principal residence; (5) burial or funeral expenses; and (6) certain expenses for the repair of damage to the employee’s principal residence. Expenses for the purchase of a boat or television would generally not qualify for a hardship distribution. A financial need may be immediate and heavy even if it was reasonably foreseeable or voluntarily incurred by the employee.
9. How Much Can I Add to my 401(k)?
If you thought there was a cap on the amount you can add to your 401(k) plan, you would be correct. For the year 2016, if you are under the age of 50 years old, you’re allowed to make a max contribution amount of $18,000. If your eligible compensation from your employer is less than $18,000 then you’re only allowed to contribute up to 100% of that amount. An example of this would be if you were paid by a clothing store $10,000 to work for the holidays, you would only be able to contribute $10,000 to your 401(k) plan with them.
This doesn’t mean if you work four jobs, making $10,000 at each of them, that you’ll be able to contribute $10,000 at each place. You will still only be allowed to add a maximum of $18,000 TOTAL towards your 401(k) plans.
An Exception to the Rule
An exception to the $18,000 contribution limit is if you’re age 50 or over by the end of the year. If you fall into this exception you’re allowed to pay an additional “catch-up contribution” amount of $6,000 for the year 2016. So if you’re already paying the max amount of $18,000, you’ll be able to add an additional $6,000 the year you turn 50. This will bring your total contribution limit up to $24,000 in the year 2016.
It doesn’t matter how old you are or how much you make when it comes to your retirement. You need to plan ahead to help ensure you retire comfortably. If you decide a 401(k) isn’t the right plan for you, I suggest you find one that is. If you don’t take the time to invest in your retirement you may end up working your whole life. As much fun as that sounds like, I think I am going to have to pass. Honestly, I’m trying to find a way to retire earlier not later!