In many households, 401(k) plans are the primary vehicle for tax-deferred saving and investing. In the competitive job market of Silicon Valley, employers find it essential to offer a 401(k) plan to attract top talent, and most companies offer this benefit to their employees. Here is a quick review of this plan’s features and benefits.
How a 401(k) May Benefit You
These tax-advantaged retirement savings accounts were developed in 1980 after passage of the Revenue Act of 1978, which contained provisions enabling their creation. Their confusing name is taken from the code section of the law that created them: Internal Revenue Code Section 401(k).
Pre-tax contributions: Traditional 401(k) plans allow you to contribute salary or wages into the plan pre-tax. Your income is reduced by the amount you contribute, and the income tax on your contribution is deferred until you take money out of the plan. This is the first of several important advantages of 401(k) plans. You reduce your taxable income by the amount you contribute to the 401(k) plan in that year.
Tax-deferred growth: Your contributions to the 401(k) plan grow tax deferred, so income taxes on earnings in the account are also deferred until you withdraw money in retirement. This is another key advantage of 401(k) plans. The lack of income tax on investment earnings in the account allows the value to grow faster than it would if it were invested in a taxable investment account.
When you withdraw money from your 401(k) plan, you take a “distribution.” Distributions are treated as taxable income to you in the year they are made. For example, if you withdraw $10,000 from your 401(k) account, you add $10,000 to your taxable income in that year. Distributions are taxed at ordinary income tax rates (not capital gains tax rates), which for many people are lower in retirement than during their career’s peak income years. This is another advantage of 401(k) plans. Income is deferred until retirement when tax on the income can be paid at lower income tax rates. If you have negative taxable income in retirement—for example, because of continuing large mortgage interest and property tax deductions—you may be able to take distributions and pay no income tax.
You do have limits on how much you can contribute to your 401(k) plan. The limits are increased periodically for cost-of-living adjustments. For 2017, the annual contribution limit is $18,000 (but not more than 100% of your compensation). If you are age 50 or older, you may also make “catch-up” contributions. For 2017, that catch-up limit is $6,000, bringing the total contribution that you can make to $24,000 if you are 50 or older (and, again, you cannot contribute more than your earnings).
Two 401(k) Rules to Remember
You have two important rules to remember for withdrawals from your 401(k) plan. First, if you withdraw from your account before you turn age 59 1/2, you will pay a penalty equal to 10% of the amount you withdraw in addition to the income tax on the amount you withdraw. The intent of this rule is to discourage you from using 401(k) funds before you reach retirement age. There are two exceptions to the early withdrawal penalty: the Age 55 Rule, which allows you to take distributions starting at age 55 in certain circumstances, and Rule 72(t), which allows for early distributions if they are part of a series of “substantially equal periodic payments” over your life expectancy.
The second rule to remember is that you must begin takeing distributions from your account by April 1 of the year following the later of the year in which you reach age 70 1/2 or retire. You must continue taking distributions by December 31 each year thereafter. The so-called “required minimum distribution” (RMD) is determined by dividing your account balance on December 31 of the previous year by a number from an IRS table that considers life expectancy. The logic behind this rule is to force you to take money out of your account and pay income tax on the withdrawn amounts. The penalties for not taking required minimum distributions are severe. If you fail to withdraw a RMD, fail to withdraw the full amount of the RMD, or fail to withdraw the RMD by the deadline, the amount not withdrawn is taxed at 50%.
Borrowing from a 401(k): A Good Idea?
You may be able to borrow money from your 401(k) plan; however, that is usually not a good idea. IRS rules allow borrowing, but your specific 401(k) may not. The maximum amount you can borrow per IRS rules is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less. Your specific 401(k) plan may not allow you to borrow the maximum amount allowed by the IRS.
One significant problem with borrowing from your 401(k) account is that if you leave the company for any reason, you must pay back your entire 401(k) loan immediately. If you cannot pay back the loan, the amount you borrowed will be treated as a distribution and you will pay income tax on that amount at ordinary income tax rates. You also will pay the 10% early withdrawal penalty if you are not at least 59 ½ years old. Another disadvantage is that the money you borrow probably will not be growing as quickly as it would in your tax-deferred 401(k) account, depending on how you used the borrowed funds. This can impair your ability to reach your retirement and other financial goals.
In next week’s blog, we will take a look at the nuts and bolts of using a 401(k) plan, including investment options and the fees and expenses you may face.