One of the smart ways to save and invest for your retirement is the employer-sponsored [b:be5e960f18]401(k) Retirement Plan[/b:be5e960f18]. This article explains the basics of the plan and highlights the following aspects:
- What is 401(k) Plan?
- How does the plan work?
- How do you benefit from the plan?
- What are its drawbacks?
- Can you take a loan from your 401(k) account?
- How can you improve your declining 401(k) balance?
What is 401(k) Plan?
How does the plan work?
- Maximum Contribution:
When you participate in a 401(k) plan, you tell your employer how much you want to pay for your retirement account. You can usually put up to 15% of your salary into the account each month, but the employer has the right to limit that amount. The IRS limits your total annual contribution to $ 15,500 (for 2008).
- Employer's Contribution:
Your employer's contribution may match yours but at different levels. A typical match might be 25%-50% of your own contribution up to a certain level.
- Investment Options:
With the new rule coming into effect from the end of October 2007, employers can select from a list of pre-approved funds which they consider suitable for long-term investments. Actively managed funds, life-cycle and balanced funds will be accepted but money market and stable value funds will be excluded from the investment list.
- Withdrawal Option:
After reaching 59 and 1/2 years you may withdraw from your retirement account without paying the penalty. But after 70 and 1/2 years you must withdraw a required amount, that is the minimum distribution. Otherwise, you will have to pay an accumulation tax as much as 50% of your required distribution.
- Added Contribution:
A Catch-Up Contribution option has been added to this retirement plan. This option enables participants aged 50 and above to increase their contribution in the retirement account. It refers to a supplementary pre-tax contribution made by the participant in excess of the IRS limit or even an employer-imposed plan limit. The annual catch-up contribution limit is $5000 for 2008.
Eligibility for catch-up contribution:-
- Participant has to be in pay status.
- They are not in the 6 months non-contribution period following the receipt of financial hardship in-service withdrawal.
- The participant's regular plan contributions must reach at least one of the following limits to qualify for catch-up contribution:
- The Annual Deferral Limit ($15,500 for 2008).
- The Plan's Deferral Limit (up to 15%).
How do you benefit from the plan?
- The money you contribute comes out of your paycheck before taxes are calculated and this means that by contributing to a 401(k), you can actually lower the amount you pay each time in current income taxes.
- All employer contribution and any growth in the 401(k) account grow tax-free till you withdraw it. Once you start withdrawing the required minimum distribution, you have to pay tax on the withdrawal at your current income tax rate.
- If your employer's contribution matches yours, the matched amount is your extra gain.
- The employee can decide where to invest current savings and/or future contributions so that he can get can get maximum returns on his investment.
- Unlike a pension plan, all contributions can be moved from one company's plan to another company's plan or to an IRA if the participant changes his job.
- The plan is protected by Pension (ERISA) laws.
What are its drawbacks?
- It is difficult to access your 401(k) savings before the age of 59 and 1/2 years but it is not impossible. In case of emergency you can withdraw from your account before you reach this age but 10% of your total distribution will be charged as penalty along with the taxes.
- 401(k) plan is not insured by the Pension Benefit Guaranty Corporation.
- Employer matching contributions do not become the property of the employee until a number of years have passed.
Can you take a loan from your 401(k) account?
However, there are demerits too. The money out of the account is not growing, there may be fees involved in the process and the loan must be paid back immediately if you change your job. Moreover any default in loan repayment is considered as an early withdrawal forcing you to pay taxes and penalties.
How can you improve your declining 401(k) balance?
- If you are investing heavily in your employer's company stock, reduce this amount and spread your investments.
- Adjust your contributions and you can contribute the maximum tax-deferred amount to your 401(k) account.
Your age and your company's plan policy will help you to decide on the strategies you adopt to repair your plan account.
401(k) is an excellent way to plan for your retirement. It helps you to increase your savings and at the same time make money by investing in the plan options. Thus, you can have complete financial security at the time of your retirement with the help of 401(k) Plan.