401K

The 401 (k) is the most popular employer sponsored retirement planning solution for W2 employees owing to its versatility and most employers offering it as a employee benefit. According to recent findings by the Investment Company Institute, the 401 k plan encompass the largest chunk, nearly two-thirds of all Defined Contribution plan assets (DC plan) with Americans holding approximately $4.7 Trillion in 401 (k) plans as of 2015. Given the benefits are higher for early-beginners, it is hardly a surprise that the highest percentage of participants in the 401(k) plans are in the younger age percentile.

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The 401 (k) plan is a qualified plan named after the Sub-section of Internal Revenue Code 401 (k) and is based on a defined contribution structure, wherein the employees can defer the tax burden on earnings, by contributing a percentage of their pre-tax income to a 401 (k) account. The employer may match the employees’ contribution to the 401 (k) partially or completely depending on their benefit strategy. Simply put, the employees do not need to pay tax on this portion of their income until they make withdrawal or get distribution from this account at retirement. Employees make contributions from pretax salary amount which aids in giving dual advantage- it helps in reducing the taxable income from payroll while ensuring the growth of earnings from the investments of deferred amount in the 401 (k) account

Additionally, in cases where the employers match the contribution to 401 (k) account, partially or wholly, acts as lucrative addition to the employees’ retirement fund. Employers can add a vesting schedule to their contributions. In case of change of jobs, the employee can rollover all of their contribution in a roll over IRA and the vested portion of the employer contribution to his 401 (k) account while exiting. There are additional benefits built-in to the 401 (k) plan wherein the employee can make early withdrawals or borrow from the account in case of critical emergencies or demonstrated hardships. The most common case of borrowing from a 401 (k) is for a home purchase which is limited to half of balance or $50,000, whichever is smaller.

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Eligibility & Annual Limits

The provision for 401 (k) account allows employers to enroll their employees into 401 (k) plans automatically with allowance of opting out if so desired. Additionally, the IRS puts caps or limits the amount of funds that can be deferred by the employee, employer or both via the 401 (k). The deferral limits as of 2017 is $18,000 and forecasted to go up within the next two years for accommodating the cost of living adjustments. The additional catch-up contribution amount for people over the age of 50 is $6,000.

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Distributions

The Required Minimum Distribution (RMD) criteria is effective at 70.5 years. However, the 401(k) assets can be withdrawn by satisfying any of the below criterion as in case of

1.Death or disability of the Employee
2.Upon the employees’ retirement or separation from the employer
3.Premature termination of the plan
4.Attainment of the age of 59.5 years by the 401 (k) account holder

Additionally, there is a provision for Hardships criteria wherein the Employee may withdraw a portion or full amount (there are additional early distribution penalties and tax deductions for this)

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Early Withdrawals & Penalties

There is a 10% penalty for early withdrawal from the 401 (k) account, i.e. withdrawal prior to the age of 59-1/2 years. In case of some qualifying disability or qualified financial emergencies which fall under accepted criterion listed by IRS, the 10% penalty may be forgiven. However, the earnings would incur taxes as per ordinary income. The participants can partake loans against the 401 (k) savings based on legally enforced agreement, however the loan amount cannot be more than 50% of the participants vested account balance (maximum up to $50,000). Additionally, the participant has to ensure minimum quarterly payments of the level amortized amount to be granted access to these funds.

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Is it for me ?

The earnings from any investment, including capital gains, dividends or interest, in the 401 (k) account are tax deferred, so its most beneficial when your current tax bracket is more than what is expected in your retirement whether in the form of . The 401 (k) plans offer a choice of diversification of assets by route of multiple investment vehicles as mutual funds, stocks, bonds etc. Thus, it provides flexibility and choice according to risk-temperament- the younger account holders may prefer a larger equity exposure than their older counterparts. Also some 401 (k) plans offer index fund options with adjustments in risk exposure between small cap, mid cap and large cap investment options.

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May be Not ?

401 (k) plans are not backed by Government or FDIC and the investments always carry a risk proposition which makes the 401 (k) undesirable for people who are highly risk averse. Also if you are in a lower tax bracket at the moment, it may make sense to pay tax now and invest via a Roth IRA which grows tax free and is more flexible.

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In Short

  • 401 (k) is a pretax retirement account provided by the employer
  • Annual limits, $18000 as of 2017
  • Taxes are paid when money is withdrawn after retirement age
  • Enrollment is automatic by some employers
  • Loan provisions, 50% of the vested account balance (maximum up to $50,000)

 

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