Money Lesson 23 - 401(K)s [Page 1]

The 401(k) plan is a type of employer-sponsored retirement plan in the United States and some other countries, named after a section of the U.S. Internal Revenue Code. A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or "deferred", into his or her 401(k) account.

A 401(k) offers three compelling benefits:

You get an immediate tax break, because contributions come out of your paycheck before taxes are withheld, thereby lowering your taxable income.
The possibility of a matching contribution from your employer -- most commonly 50 cents on the dollar for the first 6 percent you save.
You get tax-deferred growth -- meaning you don't pay taxes each year on capital gains, dividends, and other distributions

How much can you contribute to your 401(k) plan at work?

You can have your employer deduct a percentage of your pay (before taxes are calculated) and invest that money into your retirement plan account, up to the amount allowed by your plan. That amount cannot exceed the annual IRS dollar limit which is $15,500 in 2007. Cost of living adjustments, applied in $500 increments, may increase standard limits in future years. It's important to remember that your employer-sponsored retirement plan(s) may have additional limits. Some plans allow you to contribute on an after-tax basis as well. After-tax contributions also have a maximum limit determined by the IRS

Matching contributions are "free money."

Some companies offer a "match" or "matching contribution" as an incentive to join the company retirement plan. It means that the company will contribute a certain amount to your account (usually between $0.25 and $1.00) for every dollar that you contribute, up to a certain limit.

To receive the matching contribution, the plan may require that you work a specified number of years. It makes good sense to take advantage of a company match by setting aside the maximum amount required to qualify for a matching contribution. If your employer offers a matching contribution, your savings can grow that much faster.

Taking money out of a 401(k) before retirement is expensive.

Depending on your plan, you may be eligible for a "hardship withdrawal," for those unexpected circumstances when you may need your money before retirement. Loans must be repaid with after-tax money plus interest. And, with few exceptions, if you withdraw money before age 59-1/2 you must pay income taxes plus a 10 percent penalty.

The IRS recognizes four reasons for a hardship withdrawal:

Certain unreimbursable medical expenses
Purchase of a primary residence
Payments of post-secondary tuition for the next year
To prevent eviction from or foreclosure on your home

You're limited to the investments your employer chooses for your 401(k) plan

Employer contributions are subject to different limits than employee contributions. The federal annual limit on pre-tax contributions applies only to your own contributions. In addition to plan limits, you may also be subject to additional contribution limits if you are considered a "highly compensated employee." The Internal Revenue Code limits the amount of money employees and employers may collectively contribute to each employee's plan account. In 2007, the maximum is the lesser of 100% of compensation or $45,000.

What are your options when you change job?

Money Lessons


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