401(k) Plans
These accounts offer employees a tax-advantaged way to save for retirement.
August 2007
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More and more companies have turned to 401(k) plans as defined-benefit plans have become increasingly expensive. (Public-school teachers and employees of nonprofit organizations may encounter the 403(b).)
These plans get their rather awkward-sounding names from the sections of the Internal Revenue Code that authorize them. They give employees the option to divert a portion of their salary to a tax-sheltered investment account set up by the employer.
Most firms allow you to contribute between 2% and 15% of pay each year, thus lowering your taxable income. Earnings accumulate tax-free until you take the cash. Meanwhile, the company may match your contribution in whole or part.
A 401(k), because it is a defined-contribution plan, takes the investment risk off the company's shoulders and puts it on yours. Still, the attractions are considerable.
Say you make $50,000 a year and work for a company that allows you to put up to 10% of your salary in a 401(k), and say you contribute the maximum. You benefit twice, and possibly three times:
You're taxed on only $45,000, which saves you $1,250 in tax if you're in the 25% bracket.
Your $5,000 contribution grows tax free until you withdraw it.
Any amount that your company puts in as a match is pure gravy. If your employer adds 50 cents for every dollar you put in, that's an immediate 50% return on your investment.
The maximum amounts you may contribute are adjusted for cost of living. For 2007, the maximum contribution is $15,500. A "catch-up" provision for workers age 50 or older permits them to contribute an extra $5,000.
Your company can contribute more, up to limits determined each year by the Pension Plan Limitations or 25% of your pay, whichever is less. You are immediately vested in the money you contribute, but the company's contributions will probably be vested over a period of years.
Although the company plan determines the maximum contribution, you decide how much, if any, to trim your pay.
Investment choices for 401(k)s are determined by the company. They may include the company's own stock; mutual funds; or a guaranteed-investment contract, or GIC (sometimes called a "stable value" fund).
You can diversify your funds among the plan's investment alternatives, and you should periodically assess how your account is performing. The further away you are from retirement, the more of your 401(k) money should be in stock-oriented funds because of their superior long-term results. (Buying company stock through a 401(k) plan can be a good deal for employees of companies with a bright future, but for some of the potential drawbacks, see the section on ESOPs.)
Getting the money out. Because the aim of 401(k) plans is to encourage saving for retirement, the IRS puts restrictions on your ability to get at the money. You can't have it back until you leave the company, when you can roll the money into an IRA or into your new employer's 401(k) plan, if the rules of the new plan permit it.
A major exception to the no-early-withdrawal rule lets employees tap their accounts in the event of financial hardship. You must be able to prove that you're facing an immediate and substantial financial need and that you don't have another source of money. Even if you meet the hardship definition, withdrawals before age 59½ are subject to a 10% penalty. And, of course, you'll owe regular income tax on the withdrawn amount.
You may be able to tap your account early by taking a loan against your account. If your plan permits it, you can borrow as much as half of your account balance, up to a maximum loan of $50,000. Most plans require you to repay the loan within five years unless you use the money to buy a home, in which case there is no time limit. See Don't Borrow Trouble for more information on 401(k) loans.
If you leave the job in the year you reach age 55, or later, you can take your money with no penalty, although you'd probably want to roll it directly into an IRA to avoid the big tax bill. (If you take possession of the money, your employer will have to withhold 20% for the IRS. You won't get the money back until you file your tax return, showing that you have rolled the money into a qualified plan.)
If you leave before that, you can avoid the penalty and the tax by rolling the money into an IRA. In addition, you are permitted to use all or part of the money without penalty if you need it to pay medical bills that exceed 7.5% of your adjusted gross income, if you are disabled, or if you elect to receive the money in a series of equal installments based on your life expectancy.