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 plans lets employees invest a portion of their paycheck before taxes are taken out. 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 www.tdameritrade.com is quite educational

2019 401k Contribution Limits

Internal Revenue Service (IRS) adjusts the maximum contribution limits by an employee to 401(k) plans.For the year 2019 , 401k contribution limits are as under :  

Contribution Type2019 Limit
Maximum employee elective deferral.​​​​$19,000
Employee catch-up contribution (if age 50+)$6,000
Combined employee and employer contribution$56,000

What are 401(k) benefit

Here are 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 enhance the total value of 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 taxed at the tax rate applicable for that year.This is generally considered advantageous because most people will have lower taxable income during their retirement years than when they worked, meaning their effective tax rate on the amount withdrawn will be lower.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.

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 401k plan will be taxable as you will be paid all your retirement savings .

Here comes the the 401k rollover rules to save you from hefty tax implications. As per the rollover rules,your 401k plan can rollover to the new account and therefore will not have tax consequence because , practically , you did not withdrew 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 who are 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 new employer and once paperwork is over , your 401(k) plan savings will move from that account to the new one , without having to worry about withholding. In the Indirect method , you withdraw everything from the account yourself, and deposit it all back into the account yourself 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. In order 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 as though it was a cash distribution.

Rollover to IRA ?

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

401k early withdrawal penalty

401(k) plans are created for accumulating funds for retired period .Therefore, barring some exception, 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 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 which is credited your account with IRS.

Please note that some states has 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 funds 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 Traditional IRA or Roth IRA?

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

Traditional IRA Withdrawal Rules

Early withdrawals from traditional IRAs are liable to be taxed as ordinary income . The rule of that 10 percent tax penalty like 401k plan is also applicable. But traditional IRAs does not impose penalty in following cases

  1.  Qualified higher education expenses, or
  2. Unreimbursed medical expenses above 7.5 percent of your modified adjusted gross income (MAGI) or above 10 percent of your MAGI if you are under age 65, or
  3. A first-time home purchase.

Roth IRA Withdrawal Rules

The early withdrawal rule for the Roth IRA says that there will be 10 percent tax penalty for investment earnings earnings only . Your original contributions is tax-free if

  • you are at least age 59½ and
  • have held the Roth IRA for at least 5 years.

Have you taken quiz on Roth IRA ?