We Know: All About 401(K)s

What is a 401(k)?

A 401(k) is an employer sponsored contribution plan in which employees may elect to have a portion of their salaries put aside for a retirement account towards investment in a company-sponsored plan. State and federal income taxes are deferred until a distribution is taken. Employers typically make matching contributions to these accounts. These plans are named after the Internal Revenue Service (IRS) tax code of the same name.

How does the 401(k) work?

When you enroll in a 401(k) plan, you decide how much money you want to reduce from your wages (up to legal maximums set by the IRS). The money that you set aside is taken pre-tax, meaning that you do not pay income taxes on these wages until you take the distributions. Essentially, you increase your take home pay by decreasing the wages subject to current taxes. When you make a withdrawal at after you reach the age of 59 1/2, you may end up paying taxes at a lower tax bracket.

The money deducted from your wages is placed into an investment account. Many employers provide matching contributions either in the form of a fixed amount, or as a discretionary amount. Employers normally allow employees to pick and choose from a number of investment options offered by the company. Employers have the right at any time to transfer between different investment options.

Any funds that are withdrawn from the account prior to the legal retirement age is subject to a 10% penalty and a tax of at least 20% that is payed to the IRS, although this will depend on your income tax bracket.

Funds enrolled in 401Ks are different from funds invested in mutual funds or banks. 401(k) funds are taken from pre-tax earnings, while those invested in mutual funds or bank-sponsored programs are post-tax. The earnings from a mutual fund or bank are subject to taxation even though it has been invested post-tax.

You should be aware that your funds are being invested through the 401(k). You can run the risk of losing the money depending on the performance of the investment option. Thus, it is wise to diversify your investments if your company offers various options.

How much can I invest?

You can invest as much money as you'd like, up to the limit established by the Federal government. You should invest as much as you can, especially if your company provides matching contributions, to take advantage of the benefits.

What can I expect from my company's 401(k) plan?

After you've enrolled for the 401(k), your employer should provide a Summary Plan Description of the plan. At any time, you have the legal right to ask the plan administrator for a Form 5500 or Form 5500-C/R (the Summary Plan Description). You'll receive a statement of the account's performance either monthly, quarterly, or annually.

The funds that are taken from your wages towards investment must be deposited into the 401(k) accounts by the 15th of the month.

Can I take money out of the 401(k) if I need it?

Withdrawals depend on the company-sponsored plan. Some plans allow employees to make hardship withdrawals for

  • Down payments on a home of primary residence
  • To pay college tuition for the employee, spouse, or his/her dependents
  • Medical expenses that are not reimburesed
  • Payment to prevent an eviction from a residence
The disbursement is treated as a loan from yourself and is repayed with interest. If the you do not pay the loan back in its entirety, the disbursement is treated as a withdrawal that is subject to a taxrate of 20% and a penalty of 10%.

What happens to the 401(k) if I leave my job or if I am fired?

When you voluntarily or involuntarily leave the company before you reach retirement, if you have more than $5000 in your retirement account you can elect to roll the funds over to a 401(k) plan at a new job, or have the funds go directly into an IRA at your bank to avoid penalities. The direct rollover into an IRA is called a trustee-to-trustee transfer. The rollover to the IRA must take place between the bank and the former employer, who should have distribution forms to initiate the process. Any funds that go directly to you is treated as a withdrawal and subject to taxes and penalties.

What happens to my 401(k) if my company goes bankrupt?

Your 401(k) funds are protected by the Employee Retirement Income Security Act (ERISA) of 1974, which establishes guidelines on how your money is to be maintained. The 401(k) money is not considered to be part of the employer's assets if it is held in a separate account in trust for the employee.

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