Make the most of your 401(k)
Key Points
- What Is a 401(k)?
- Tax Treatment of 401(k) Plans
- Matching Contributions
- Consider the Advantage of Tax Deferral
- 401(k) Advantages
- Tax-Deferred Compounding
- Choosing Investments
- When You Change Jobs
- Borrowing From Your Retirement Plan
- Work With Your Financial Advisor
- Points to Remember
As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. That's because 401(k) plans offer a variety of attractive features that make investing for the future easy and potentially profitable. Be sure to talk to your employer or plan administrator about the specific features and rules of your plan.
What Is a 401(k)?
A 401(k) plan is an employee-funded savings plan for retirement. It takes its name from the section of the Internal Revenue Code that created these plans. 401(k) plans are also known as "qualified defined contribution" retirement plans: qualified because they meet the tax law requirements for favorable tax treatment (described below); and defined contribution because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.
Tax Treatment of 401(k) Plans
The 401(k) plan allows you to contribute up to $16,500 of your salary in 2009 to a special account set up by your company. Future contribution limits will be adjusted for inflation. Keep in mind that individual plans may have lower limits on the amount you can contribute. In addition, individuals aged 50 and older who participate in a 401(k) plan can take advantage of so-called "catch-up" contributions of an additional $5,500 in 2009.
401(k) plans now come in two varieties: traditional and Roth-style plans. A traditional 401(k) plan plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.
The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax free; you pay no taxes on qualified distributions.
Distributions from IRA plans need to be qualified. In general, this means, that for a traditional IRA, they must be taken after 59 ½ (or age 55 if you are separating from service from the employer whose plan the distributions are withdrawn), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.
The rule pertaining to age 55 does not apply for Roth 401k tax free distributions. However, the money being withdrawn needs to have been in the plan for five years and you must be age 59 ½, or qualify for a hardship exception, in order to obtain a tax-free distribution.
Pre-tax and Roth deferrals can't exceed the lesser of 100% of compensation and $16,500 if age 49 or younger, or $22,500 if age 50 or older. After-tax deferrals can be made above these limits as long as total contributions, including employer matching and profit sharing contributions, don't exceed 100% of comp or $49,000 if you are age 40 or younger, or $54,500 if you are age 50 or older. Check with your plan administrator for details.
Matching Contributions
Besides its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a Traditional 401(k) plan, is taxable when withdrawn.
Employer contributions may require a "vesting" period before you have full claim to the money and their investment earnings. But keep in mind that if your company matches your contributions, it's like getting extra money on top of your salary.
Consider the Advantage of Tax Deferral
As you evaluate the potential benefits of a 401(k) plan, consider the advantage of tax deferral. This chart shows the result when a hypothetical $100 monthly investment is made for 30 years in a traditional 401(k) plan versus a fully taxable investment account. The chart assumes an annual 8% average rate of return compounded monthly and a 25% tax rate, although a lump sum distribution may push you into a higher bracket. For simplicity, it assumes the taxable account earns interest income only, which is taxed at the end of each calendar year. The chart shows that even if the entire amount in the 401(k) plan was withdrawn after 30 years and taxed, there would still be more money left than in the taxable account. Bear in mind that withdrawals from a 401(k) plan before age 59 1/2 may be subject to penalty taxes, unless you separate from your employer during or after the year in which you turn 55. This example is hypothetical and not indicative of future performance in your retirement plan.
401(k) Advantages
- Tax-deferred contributions and earnings on traditional plans.
- Tax-free withdrawals for qualified distributions from Roth-style plans.
- Choice among different asset classes and investment vehicles.
- Potential for employer-matching contributions.
- Ability to borrow from your plan under certain circumstances.
Tax-Deferred Compounding
The benefit of compounding reveals itself in a tax-advantaged account such as a 401(k) plan. As the accompanying chart shows, if your $100 monthly contribution accumulates tax deferred over 30 years, you could grow your retirement nest egg to $150,030. That's a difference of almost $50,000 just because you didn't have to pay taxes up front!1 Of course, you'll have to pay taxes on earnings and deductible contributions to a traditional 401(k) when you withdraw the money. But that will likely be when you are retired and may be in a lower tax bracket.
Choosing Investments
Generally, 401(k) plans provide you with several options in which to invest your contributions. Such options may include stocks for growth, bonds for income, or money market investments for protection of principal. 2 This flexibility allows you to spread out your contributions, or diversify, among different types of investments, which can help keep your retirement portfolio from being overly susceptible to different events that could affect the markets.
When You Change Jobs
When you change jobs or retire, you generally have four different options for what to do with your plan balance. You can keep the plan in your former employer's plan, if permitted; you can transfer balances to your new employer's plan; you can roll over the balance into an IRA; or you can take a cash distribution. The first three options generally entail no immediate tax consequences; however, taking a cash distribution will usually trigger 20% withholding, a 10% IRS penalty tax if taken before age 59 ½ (unless you separate from your employer in a year in which you turn 55 or older), and ordinary income tax on pretax contributions and earnings.
When deciding on which of the first three options to choose, you should consider available investment options and ease of access. Often, rolling over to an IRA provides the greatest flexibility and control, while affording a wide choice of investment alternatives.
Borrowing From Your Retirement Plan
One potential advantage of many 401(k) plans is that you can borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you.
If you leave the company, however, you may have to pay back the loan in full immediately, depending on your plan's rules. In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.
Work With Your Financial Advisor
A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult with your plan administrator or financial advisor to help you determine how your employer's 401(k) plan could help make your financial future more secure.
Points to Remember
- A traditional 401(k) plan allows you to defer taxes on part of your salary. A Roth 401(k) accepts after-tax contributions, but allows for tax-free withdrawals in retirement.
- Contribution limits are $16,500 in 2009 ($22,000 if age 50 or older). Future contribution limits will be indexed for inflation.
- One of the biggest advantages of 401(k)s versus other retirement plans is that employers may match part or all of the contributions you make to your plan.
- 401(k) plans provide you with several options in which to invest your contributions.
- If you leave your company and take a cash distribution, taxes and penalties will likely apply.
- Some 401(k)s allow you to borrow as much as 50% of your vested account balance, up to $50,000.
1This example is hypothetical in nature and is not indicative of future performance in your retirement plan. Withdrawals prior to age 59 ½ are generally subject to a 10% IRS penalty tax, unless separation from employer occurs in year during which the individual turns 55 or older.
2An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.
Neither Ameriprise Financial nor its affiliates may provide tax or legal advice. Consult with your tax advisor or attorney regarding specific tax issues.