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What is a 401(k) plan?

What is a 401(k) plan?

Many employers sponsor a retirement savings plan for their employees. Under these plans, also commonly known as defined contribution plans, you can save money toward your retirement on a tax-deferred basis – that is, you don't pay federal or state income taxes on your savings or their investment earnings until you withdraw the money at retirement.

Most people's taxable income – and therefore, their tax rate – is lower at retirement than during employment, so they end up paying considerably less in taxes on their savings.

The most common types of employer-sponsored retirement savings plans are called 401(k), 403(b) or 457 plans – so named for the Internal Revenue Service tax codes that govern them – and Thrift Savings Plans. Each has a different target audience:

  • 401(k) plans are offered to employees of public or private for-profit companies.
  • 403(b) plans are offered to employees of tax-exempt or non-profit organizations, such as public schools, colleges, hospitals, libraries, philanthropic organizations and churches.
  • 457 plans are offered to employees of state and local municipal governments (and some local school and state university systems).
  • Thrift Savings Plans are offered to federal civilian and uniformed services employees.

These plans have many features in common, although contribution limits, vesting schedules for employer-matching contributions, investment options and other details may differ, so be sure to read the plan documents for your particular plan carefully.

How do 401(k) Plans Work?
With a regular 401(k) plan, money is deducted from your paycheck before taxes are withdrawn, which lowers your taxable income and therefore, lowers your taxes.

Some plans allow you to contribute money on an after-tax basis as well. Check with your financial advisor for cases when this might be advantageous in your situation.

In addition, many employers have begun offering Roth 401(k) plans, which combine the features of a regular 401(k) with those of a Roth IRA. With a Roth 401(k) you contribute after-tax dollars. Although you don't get an upfront tax break, your account grows tax-free and withdrawals aren't later taxed, provided you’ve had the account at least five years and are age 59 ½ or older – or have become disabled or die.

Eligibility For Participation
Some employers apply a waiting period before you can begin participating in their 401(k) – anywhere from one month to one year – while others allow employees to begin making contributions immediately. Also, it's not unusual for an employer to wait until you pass a similar waiting period before it will begin making matching contributions to your account. Check your benefits enrollment materials to see what, if any, waiting periods must be met.

Contribution Amounts
The IRS sets a maximum amount you can contribute to a 401(k) plan in any given year and it is usually adjusted upward to account for inflation. For 2014, this limit is $17,500. In addition, employees over age 50 can also make "catch-up contributions" of up to $5,500 above and beyond the maximum amount.

Most plans let employees contribute a percentage of covered compensation, in whole percentages, up to a specified percentage – usually up to a maximum of about 20 percent to 25 percent of covered compensation. (Note: The definition of “covered compensation” usually means total salary, but it varies from employer to employer, so check your plan documents.) This upper percentage amount could conceivably limit your ability to reach the legal maximum contribution, depending on your pay. For example, if you earn $35,000 a year and your employer limits contributions to 20 percent of pay, you could only contribute up to $7,000 a year ($35,000 X 0.20 = $7,000).

Employer Matching Contributions
Although not required to by law, many employers match a portion of the contributions employees make to their 401(k) account. These matching contribution amounts vary widely from employer to employer (usually from 25 percent to 100 percent of your contributions, up to a set percentage of your pay). In addition, some employers will increase their match based on your years of service.

Vesting Schedules
You are always 100 percent vested in (that is, have complete ownership of) your own contributions to your 401(k) account. Some employers make you fully vested in their matching contributions immediately, while others have a vesting schedule outlining how much of the company-matching contributions and their investment earnings you own at any given time. In the latter case, if you left the company before being fully vested, you would lose a portion of the company-matching contributions (but not of your own contributions). Check your plan documents to see if this applies.

Your retirement savings in a 401(k) plan can really add up over time: Say you earn $35,000 and are in the 25 percent marginal tax bracket. Contributing 6 percent of your pay ($2,100) lowers your taxable income to $32,900, reducing income taxes by $525. A 50 percent employer match of the first 3 percent of earnings you contribute would add another $525 to your account. So, you would pay only $1,050 for $2,100 in annual savings, or $87.50 a month. To save that same $2,100 on an after-tax basis would cost you $175 a month.

You may begin taking money from your account without incurring an early withdrawal penalty at age 59 ˝. In addition, you will be exempt from this penalty if you are over age 55 and have been let go by your employer, or if you become totally disabled.

The laws governing 401(k) plans require that you begin withdrawing money from your 401(k) plan by the age of 70 ˝, unless you are still a full time employee with the company sponsoring your 401(k). These distributions are considered income and subject to income tax.

Changing Employers
If you leave your employer, you have several options for what to do with your 401(k) account balance:

  • Roll over your account balance into your new employer's plan.
  • Roll over your account balance into an Individual Retirement Account (IRA).
  • If allowed by your former employer, you may leave your balance in its plan (although, for account balances below $5,000, your employer may require you to close your account).
  • Withdraw your account balance in a lump sum cash payout.

The last option may sound tempting, but it is almost never a good idea. Not only will taking a lump sum distribution significantly reduce your retirement savings, but you'll likely face severe tax consequences. You'll have to pay federal (and possibly state) income tax on the amount, plus a 10 percent early withdrawal penalty unless you qualify for an exemption (e.g., if you're over age 55 or disabled). And, because your employer is required to withhold 20 percent of your distribution for federal taxes, your cash payout could be significantly less than you were expecting.

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