Thursday, April 25, 2024

All about 401(k) Retirement Plans

A 401(k) is a retirement savings plan bought by an employer for its employees. This plan -401(k) is named for the section of the Internal Revenue Code that governs them. The 401(k) retirement plan lets employees invest a portion of their paycheck before taxes are released. With a 401(k), you control how your money is invested. Most plans offer a spread of mutual funds composed of stocks, bonds, and money market investments. Here is a 401k calculator.

401(k) Explainer Video

This video explaining 401(K) retirement plans by is quite educational.

What are 401(k) benefit?

Here are the major benefits of investing in 401(k) retirement savings plans.

  1. Employers can contribute up to a certain extent of the employee’s income, usually up to 4% of annual income. This enhances the total value of the retirement corpus.
  2. The US tax code provides tax relief for investment in 401(k) plans by providing that when employees earn and invest, they do not have to pay income tax during that year. The tax is applicable in the year of withdrawal.
  3. These 401(k) plans offer a useful target for retirement savings.
  4. The withdrawals from 401(k) plans are taxed in the year of withdrawal and at the tax rate applicable for that year.This is generally considered advantageous because most people will have lower taxable income during their retirement than when they worked, meaning their effective tax rate on the amount withdrawn will be lower.

Types of 401(k) Plans

There are mainly two types of 401(k) you choose= Traditional IRA and Roth IRA. Here’s the breakdown of each:

401k type Tax rules
Traditional IRA The contribution from salary is before taxes from each paycheck, so taxable income drops by the amount you contribute. Taxes are paid at the time of withdrawal
Roth IRA IN this case contributions are made out of income that’s already been taxed. So ,no taxes paid upon withdrawal.

401k contribution limits 2023 & 2022

Provision2023 limit2022 Limits
Maximum 401(k) contributions$22,500$20,500
Maximum compensation limit$330,000$305,000
Highly compensated employees
  Earning (in the previous year) more than

Key employee compensation limit$215,000$200,000
The annual contribution limit for defined contribution plans$66,000$61,000
Annual benefit limit for defined benefit plans$265,000$245,000
SIMPLE plan limit$15,000$14,000
Age 50 and older catch-up contribution limit
All plans other than SIMPLE plans
SIMPLE plans

Annual contribution limit for Section 457 deferred compensation plans (government and tax-exempt organizations)$22,500$20,500
Employee stock ownership plan (ESOP)
Maximum account balance subject to a five-year distribution period
Each incremental dollar amount in excess of the account balance adds one year to a five-year distribution period

Simplified employee pension (SEP) plans
Contributions must be made for employees earning at least

409A minimum specified employee (officer) compensation requirement$215,000$200,000
409A involuntary separation pay exception$660,000$600,000

What are 401k Rollover Rules and Restrictions?

As stated earlier, 401(k) contributions are not taxed as income in the year that the contribution is made (the amount is deducted on the employee’s annual income tax returns); withdrawals are taxed instead in the year of withdrawal and taxed at the tax rate applicable for that year.But, let us say, you change jobs, then the payment from the 401k plan will be taxable as you will be paid all your retirement savings.

Here are the 401k rollover rules to save you from hefty tax implications. As per the rollover rules, your 401k plan can roll over to the new account and, therefore will not have tax consequences because , practically, you did not withdraw your retirement savings but just rolled over to another account. IRS has set some rules for rolling over the 401(k) plans. These are:

  • The rollover has to happen to another account within 60 days.
  • For those not yet 59 1/2 years old, all contributions made to the plan are eligible for rollover to the new plan, without a tax consequence.

Types of Rollovers

Rollover of 401k plans can be either direct or indirect. The direct rollover way of rollover is simple. You open a new account with a new employer, and once the paperwork is over, your 401(k) plan savings will move from that account to the new one without worrying about withholding. In the Indirect method, you withdraw everything from the account and deposit it all back when you are ready. The employer is required to withhold 20% of the amount, just in case you do not deposit all of the money back into another account within 60 days. To avoid the tax implications, you must deposit all the money, even the 20% withholding amount, back into another account within 60 days. If you do not, it will be treated like a cash distribution.

Rollover to IRA?

The rollover of the 401k plan savings to an IRA or Individual Retirement Account could be resorted to if you did not get the job after losing an earlier job. IRA provides tax benefits and protects the money you have already invested into the 401k plan.

401k early withdrawal penalty

401(k) plans are created for accumulating funds for a retirement period. Therefore, barring some exceptions, early withdrawal is discouraged. Therefore, IRS will impose a tax penalty for an early withdrawal from a 401k or IRA account. In other words, tax laws provide that if your age is below 59½ and you are withdrawing early from your 401(k) plan, there may be the following immediate consequences:

  1. The amount of withdrawal from 401(k) will be added to your income for the year and taxed as ordinary income.
  2. There will be a 10 percent penalty.
  3. You will typically have 20 percent withheld from the distribution credited to your account with IRS.

Please note that some states have rules to impose further tax in case of early 401k withdrawal.

Exceptions to early penalty for 401k withdrawal

Penalty rules for early withdrawal have some exceptions to cover situations wherein the fund’s withdrawal is a necessity like

  • total and permanent disability or
  • loss of employment when you are at least age 55, or
  • a qualified domestic relations order after a divorce which is an order or judgment that directs the retirement plan administrator on how these assets should be distributed.

What about withdrawal from a Traditional IRA or Roth IRA?

There is some difference in withdrawal rules. These are highlighted below:

AspectTraditional IRARoth IRA
Taxation on contributionsPre-tax contributions, reducing taxable incomeAfter-tax contributions, no tax deduction
Taxation on earningsEarnings grow tax-deferredEarnings grow tax-free
Taxation on withdrawalsTaxed as ordinary income at your current tax rateQualified withdrawals are tax-free
Qualified withdrawalsMust be at least 59 ½ years old and held account for at least 5 yearsMust be at least 59 ½ years old and held account for at least 5 years
Early withdrawal penalty10% penalty on the amount withdrawn (some exceptions may apply)10% penalty on earnings withdrawn (some exceptions may apply)
Required minimum distributions (RMDs)Must begin at age 72, taxed as ordinary incomeNo RMDs required during the account holder’s lifetime

Have you taken quiz on Roth IRA ?

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