What is 401(k)
Put simply, 401(k) is a way (retirement savings account) which helps you to reduce your taxable income.
401(K) Offers Convincing Benefits.
Here is a guide to 401(k). 401(k) reduces your taxable income as contributions are provided from your pay before implying tax on them. There can be a matching contribution from the employer and the money you save through the process can benefit from the tax deferred growth. In easier words 401(k) lets your money compound quicker as compared to the circ*mstances if it was taxed earlier.
If you contribute some of your salary to 401(k), you can benefit from:
- An immediate tax break as contributions are taken before tax,
- A matching contribution from your employer sometimes
- Tax deferred growth because you don’t pay taxes on the investments
The Guide
Federal limit on 401(k) contributions
In 2013, the limit on annual pre-tax contribution is $17,500, or $23,000 for people at the age of 50 or older. This federal limit is increasing gradually and if you are above the age of 50, you can make an additional contribution of $5500.
One important thing to remember is that federal laws set a guide to 401(k) but your employer can make strict restrictions and it takes a while to implement changes in your plan.
Additionally, for a 401(k) plan, you need to go through other non-discrimination federal tests. These are for highly compensated employees. This means that the people who make at least $115,000 annually are not permitted to contribute equal to the salary percentage similar to your less paid colleagues.
“Free money”
You should contribute at least enough to get a matching contribution or ‘free money’ even if you can’t max out your 401(k). Normally, there is a 50 cents match on a dollar and up to 6 percent of your salary.
Taking money out before retirement.
You need to re-pay loans from the interest plus after tax money and if you want to withdraw your money before retirement, it is expensive. Withdrawing before the age 59-1/2 would mean a penalty of 10% along with paying taxes. Also, time you lost for compounding your money will shrink your wealth.
Select a portfolio of stocks and bonds
In order to select the stocks and bonds for your 401(k) investment, two factors will be considered in accordance to guide to 401(k): your time horizon till you retire and how much risk can you tolerate.
Investments are chosen by your employer
A guide to 401(k) allows employer to choose the investments. If you don’t like them, try not to abandon the plan because you can lose the matching contribution and compounding.
Options if you quit your job
You have three choices if you leave your job. You can let go your 401(k) money, roll it into another 401(k) or cash them. Your employer might insist to take them out if the account has a balance less than $5000 but doing this is no use. It better to roll them into another account because even small amounts of money can grow large through compounding and time.
Rolling money into an IRA
According to guide to 401(k), this makes it a “trustee-to-trustee” transfer. In easier words this means the check will be in the name of you knew custodian, not you.
Early withdrawals without penalty
One way to do this is through IRS rule 72(t). According to guide to 401(k), you are allowed to take a fixed amount for five years or until you reach 59-1/2, the longer one is given. You life expectancy determines the annual amount you can withdraw.
Leave money in your 401(k) account when you retire.
Find out about any rules the employer has imposed on the collection of distributions. If there are no specific rules, you can leave your money there till the age of 70-1/2 as this is the age Uncle Sam wants retirees to start withdrawing.
Well, Uncle Sam gives only a few gifts, 401(k) being one of them. Who would refuse free money? Probably no one. The more you invest the more return you will get.
With such tax advantages, don’t consider this a penalty free scheme. As we mentioned earlier, withdrawing before time will charge you extra 10% penalty and you will also have to pay taxes on that amount which previously you had enjoying skipping. Another thing you need to take care about is that time you need to stay with your job so that you can benefit from 100% of your employer matches.
If you haven’t thought about your retirement plans yet, its time you start planning about it. This was a quick guide to 401(k) and if you plan on implementing it, you must study in great detail.
