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The federal government established the 401k plan as a way for people to save for their retirement. In order to encourage savings, the government created special tax advantages for 401k participants.
Your 401k plan is an incredible investment opportunity designed to assist you in reaching your retirement goals. Every company's 401k plan is a bit different, however. It was set up by your employer as a simple, convenient retirement savings vehicle that delivers significant tax benefits while you are working. It enables you to build personal wealth in the future.
Your Summary Plan Description (SPD) will provide you with more detail on the specifics of your plan. Ask your Human Resources Department for a copy of this document.
Your 401k plan helps you to start and stick with regular investing. Your contributions are automatically deducted from your salary before you receive your check. Since the money is deducted from your gross income, you will have lower taxable income, which means you will pay less in annual taxes. You couldn't ask for a simpler way to save!
The money you save will accumulate on a tax-deferred basis. This means you pay no Federal or State taxes on your contributions or investment earnings until you start withdrawing money from the plan. The benefit of a tax deferred account is that your dollars accumulate more quickly because your earnings are exempt from current taxation.
If you are under the age of 50, the 2012 limit for contributions to your 401k plan is $17,000. This limit is generally adjusted for inflation in $500-$1,000 increments annually. In addition, highly compensated employees are usually limited in how much they can defer due to IRS testing requirements.
If you are over the age of 50, you now also have the option of making "catch-up contributions" in order to accelerate your savings. As mentioned above, the maximum amount of employee contributions for the year 2012 is $17,000. However, if you are over 50, you have the option of contributing an additional $5,500, bringing the limit up to $22,500. Similar to the increases in the contribution limits, this "catch-up contribution" amount may also be adjusted annually for inflation.
For more information, please contact your Human Resources Department.
The "vested" portion of your 401k account is the part that is yours and that cannot be forfeited. To better understand, consider that there are two types of 401k contributions: the contributions you make and the contributions your employer makes (such as "matching" contributions).
The money you contribute to the plan is always 100% vested. In other words, whatever money you put into the plan, adjusted for any investment gains or losses, is always 100% yours.
The money your employer contributes, however, may be subject to a vesting requirement. Vesting requirements are very common in 401k plans and simply mean that you must earn your employer's contribution over time. For example, if you have only worked for the company for three years, which equals 40% vested under your plan's vesting schedule, you would only be entitled to $40 of every $100 contributed by your employer.
Your account will be exposed to a variety of types of risk depending upon how you choose to allocate your funds between investments. Investing in stocks, for example, exposes you to the everyday volatility of the market, but long-term they often tend to have the highest potential for gains. If you choose to invest in foreign stock, you run the risk that a political problem may arise overseas or that exchange rates will drop, thus affecting your return. If you invest in bonds, there is a chance that interest rates drop, and the possibility that inflation may be higher than your return, meaning that you are actually losing money. There is no way to escape the risk that your investments will decrease in value, although some types of investments are seen as "less risky" and others as "more risky". Bonds, for example, are seen as less risky when compared to stocks. However, generally speaking, the higher the risk the higher your potential for greater gains. While it is impossible to completely avoid risk, there are certain things that you can do to decrease your chances for losses in your account. Most importantly, avoid putting all of your money into one fund, or one type of fund. Spread your assets among a variety of funds within your plan so that if one fund is not doing well, you have a chance for your other investments to make up for any losses. Bear in mind that everyone has a different tolerance for risk and the closer you are to retirement, the more closely you may want to guard your amount of risk exposure.
If you switch jobs, you have three options for what to do with the vested portion of your 401k account. The following outlines your options and tax implications for each:
Yes, if your new company's plan allows rollovers. If you roll over your 401k money into another company's 401k plan, you maintain the account's tax-deferred status and will not have to pay taxes on your 401k assets until you withdraw money from the plan.
If your new company does not allow rollovers, you have two other options that would allow you to maintain the account's tax-deferred status:
If your vested account balance is $5,000 or more and you're under age 65, you can leave your money where it is -- and taxes won't be due until you withdraw money from the plan.
You can roll over your 401k into a rollover IRA account. If you request a direct rollover, meaning that the money is transferred directly into the new account, you won't owe taxes until you withdraw money from the account.
Ten percent of the untaxed money you withdraw, plus applicable federal, state and local taxes on that amount. So if you withdraw $5,000 from your 401k before age 59 1/2, you would owe a penalty of $500 (plus applicable federal, state and local taxes on the entire $5,000). To withdraw money before age 59 1/2 and avoid the 10% premature withdrawal penalty, you have to meet one of the following criteria (subject to the rules of your 401k plan):
Any money withdrawn for the above reasons is still subject to applicable federal, state and local income taxes.
The 10% penalty applies to the entire untaxed amount that you withdraw. If you withdraw $5,000 from your 401k before age 59 1/2, you would owe a penalty of $500 (plus applicable federal, state and local taxes on the entire $5,000). If you've made after-tax contributions to your 401k, it gets a bit more complicated.
You do not have to pay the 10% penalty or any additional taxes on the amount of your after-tax contributions. You do, however, have to pay the 10% penalty and all taxes due on any interest earned and employer-matching contributions made as a result of your after-tax contributions. If you're thinking "I'll just take out my after-tax contributions and leave the earnings where they are" -- nice try, but no dice. For every after-tax contribution dollar you withdraw, the IRS requires you to withdraw a proportional amount of the earnings, too.
To avoid paying current income taxes and the 10% penalty you can roll your account balance over into an IRA. To learn how to open an IRA account and roll over your 401k balance visit the IRA Center.
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