401(k) Investment Guide
About the 401(k) Guide
This guide covers the basics of the 401(k): what it is, what it means to rollover a 401(k), what the rules and contribution limits are, how loans are taken against a 401(k), and what to do if you're self-employed and not covered by employer-sponsored plan. While this guide provides an overview and general advice, it's recommended to seek the advice of a qualified advisor or Certified Public Accountant in order to receive specific information about your individual financial situation.
What is a 401(k) Plan?
A 401(k) plan is an employer-sponsored defined-contribution plan. A defined-contribution plan is one in which the employee makes the primary contributions to his or her own account while working. This is different than a defined-benefit plan, which means that the employer makes the contributions to the employee's account, even after the employee has stopped working.
Over the past several decades, more American companies have begun offering defined-contribution plans while phasing out defined-benefit plans. The reasons for this are entirely economic. First, defined-contribution plans like pensions and profit sharing plans have become more expensive as Americans live longer. Companies that based their future defined-benefit program payments on a life expectancy of 72 are finding it nearly impossible to continue payments for retirees who now live to 75, 78 and beyond. Second, American companies are finding it increasingly difficult to compete with foreign companies that do not offer defined-benefit plans. Companies that do offer the plans must pay for them by increasing the price of their product or service. Finally, as a way to encourage workers to increase their retirement savings, the government has created numerous tax advantages as an incentive to save.
A 401(k)s is a tax-deferred account funded with pre-tax dollars. In other words, the contribution you make every two weeks via a deduction from your paycheck is not taxed in the year that it is earned. For example, if you made $80,000 in 2010 and contribute $8,000 to a 401(k), you will pay tax on $72,000, less other deductions. It's important to remember, however, that tax-deferred is not the same as tax-deductible. Tax-deferred means that current tax liability is reduced. Tax payments are put off until some point in the future. Tax-deductible means that tax liability is entirely eliminated, with no tax owed in the future.
Employers that offer 401(k) plans may also provide a matching contribution. While this can add up to a significant amount of money for an individual and for all of the employees as well, employers who offer a matching contribution know that the expense is capped. Whereas a defined-benefit plan promises the employee a guaranteed amount of money for life, contributions to an employee's 401(k) account are matched up to a certain level, end when the employee's service to the company ends, and can be discontinued at any time as long as contributions for all other employees end at the same time. Since the employer match is based on salary, employers also know at the beginning of each year what the expense of the contributions will be for the year to come.
To see anwsers to 36 of the most common 401(k) questions, visit the 401(k) FAQ.
Types of 401(k) Plans
There are three main types of employer-sponsored 401(k) plans: Traditional, safe harbor and Simple. A traditional 401(k) plan is what most people are familiar with. An employee makes contributions to his or her account via payroll deductions and the employer provides a matching contribution. In almost all cases, the employer match is up to a percentage of the employee's salary. For example, an employer might match 100% of the employee's contribution up to 6% of his or her salary. The standard vesting schedule for a traditional 401(k) is 3-5 years. Each year, you become vested in a larger percentage of your employer's contribution until the completion of the final year, at which point the full value of the account is yours.
A safe harbor 401(k) works the same way as a traditional 401(k) except that employees are fully vested in all employer contributions immediately at the time they are made.
Simple 401(k) plans are limited to companies with 100 employees or fewer. Like the safe harbor 401(k), employees are fully vested in employer contributions at the time they are made.
To rollover a 401(k) means to transfer it from one tax-qualified account to another. It's important to understand that the money must be moved into a tax-qualified account in order to avoid penalties and having to declare the distribution as income. A tax-qualified account can be established at a brokerage house, mutual fund company, or a bank.
When leaving a job, you are given the opportunity to take the vested portion of your 401(k) with you. You are always 100% vested in the amount of money that you have contributed. But you may have to complete a predefined number of years of service in order to have the full value of your employer's contribution.
If a 401(k) is moved into an IRA without receiving the proceeds of the account first, it is considered a direct rollover. This means that proceeds did not pass into the owner's hands at any point. If the money is received and then used to establish the rollover IRA, it is considered an indirect rollover. If you choose an indirect rollover, your employer is required to take 20% out of the distribution. You have 60 days from the time you receive the money to the time it must be deposited into a new tax-qualified account.
For more details, visit the 401(k) Rollovers page.
401(k) Rules and Contribution Limits
If your employer sponsors a traditional or safe harbor 401(k) plan, you are allowed to contribute up to $16,500 in 2010 and 2011, provided you are under the age of 50. If you are 50 or older, you are now allowed to make a "catch up" contribution of an additional $5,500 in 2010 and 2011, for a total of $22,000.
If your employer sponsors a Simple 401(k) plan, you are allowed to contribute up to $11,500 in 2010 and 2011 if you are under age 50. If you are age 50 or older, you can contribute an additional $2,500 in 2010 and 2011.
For more details, visit the 401(k) Rules and Limits page.
Money can be borrowed from a 401(k) provided the employer allows for it. Employers that do allow for borrowing typically do not specify under what circumstances the money can be used. However, some will require the money only be used for emergencies, the purchase of a home, or college tuition.
Federal law limits the amount that can be borrowed to 50% of the vested balance. Note that in the case of a partial vested 401(k), you cannot borrow against the full account value. The maximum amount you can borrow at any one time is $50,000. The loan must be paid back in five years, unless it has been used to purchase a home.
While it may not always make sense to borrow against a 401(k), there are times when it may be a good choice. For example, if you have high-interest credit card debt and a low credit score, it might be a good idea to borrow against your 401(k) to pay off the debt. The typical interest rate on a 401(k) loan is the prime rate plus 1%. That is much lower than the rates paid on credit cards, which can reach over 20%.
If you do borrow against your 401(k), be aware that if you lose or leave your job, you will be required to repay the loan in full within 60 days. Otherwise, you will be subject to early distribution penalties and have to declare the money as income earned. Those nearing retirement age are not allowed to begin taking distributions until the loan is paid back in full.
For more details, visit the 401(k) Loans page.
The Solo 401(k)
The self-employed, either as an unincorporated sole proprietor or incorporated as an LLC or subchapter S, can also establish and contribute to a 401(k). Commonly referred to as a solo 401(k), if you have no employees except you and your spouse, a solo 401(k) allows both of you to contribute up to $49,000 ($54,500 if you are 50 or older).
The contribution is actually made up of two parts. The first is the portion of your salary on which you are deferring taxes. This is the same amount, $16,500 ($22,000 if you're 50 or older) that you would be allowed to contribute to an employer's plan. The second is the profit sharing portion. This is equal to 20% of net profits if you are taxed as a sole proprietor or 25% of reported W-2 earnings if you are taxed as a corporation.
For more details, visit the Solo 401(k) page.
Getting Free 401(k) Money
Whatever the options, the best advice is to contribute at least the amount of your employer's matching contribution. The matching 401(k) contribution is literally "free money". And free money, combined with the contributions andtax-deferred growth, will go a long way to providing a comfortable nest egg for retirement.
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