Guide to Your 401(k)

March 30th, 2015

1. A 401(k) offers three compelling benefits.

A 401(k) represents a way to reduce your taxable income since contributions come out of your pay before taxes are withheld; many plans include a matching contribution from your employer; and the money you save benefits from tax-deferred growth, which lets your money compound more quickly than it would if it were taxed yearly.

2. The federal limit on annual pre-tax 401(k) contributions is on the rise.

In 2013, the maximum contribution is $17,500, or $23,000 if you’re 50 or older.

3. Matching contributions are “free money.”

If you can’t afford to max out your 401(k), contribute at least enough to get the matching contribution, a.k.a.. free money. The typical match is 50 cents on the dollar up to 6% of your salary.

4. Taking money out of a 401(k) before retirement is expensive.

Loans must be repaid with after-tax money plus interest. And, with few exceptions, if you withdraw money before age 59-1/2 you must pay income taxes plus a 10% penalty. What’s more, lost time for compounding will substantially shrink your nest egg.

5. When setting up your 401(k) investments, figure out what your mix of stocks and bonds should be.

Two factors influence this decision: your time horizon until retirement and your risk tolerance.

6. You’re limited to the investments your employer chooses for your 401(k) plan.

If you don’t like many of the selections, keep your choices simple by investing, for example, in a broad-based index fund. Don’t boycott the plan altogether. If you do, you lose out on tax-advantaged compounding and a matching contribution.

7. When you change jobs, you’ll often have three choices: leave your 401(k) money where it is, roll it into an IRA or another 401(k), or cash out.

If your account balance is less than $5,000, your employer may insist you take it out of the plan, but cashing out is like shooting yourself in the foot financially. Even small amounts can grow large with time and tax-deferred compounding. You’d be better off rolling the money into another retirement account.

8. When you do roll money into an IRA or 401(k), make it a “trustee-to-trustee” transfer.

That is, have the check made out to the custodian of your new account, not you. Otherwise, you risk possible penalties if you fail to execute the rollover properly.

9. IRS rule 72(t) provides one way to take early 401(k) withdrawals without penalty.

You must take a fixed amount of money out for five years or until you reach 59-1/2, whichever is longer. The annual withdrawal amount is based on your life expectancy.

10. Some employers let you leave money in your 401(k) account when you retire.

Find out what rules, if any, the employer imposes on when and how you must start taking distributions. If there are none, you may leave the money untouched until you’re 70-1/2. That’s the age when Uncle Sam insists all retirees begin withdrawing money from traditional IRAs and 401(k)s.

Why invest in a 401(k)?

Uncle Sam doesn’t offer many gifts, but a 401(k) is one of them.

If someone offered you free money, would you refuse it? Probably not. But that’s just what you’re doing if you don’t contribute to your 401(k). The more you contribute, the more free money you get. Here’s why:

Contributing part of your salary to a 401(k) gives you three compelling benefits:

  • You get an immediate tax break, because contributions come out of your paycheck before taxes are withheld.
  • The possibility of a matching contribution from your employer — most commonly 50 cents on the dollar for the first 6% you save.
  • You get tax-deferred growth — meaning you don’t pay taxes each year on capital gains, dividends, and other distributions.

The federal limit on annual contributions has been increasing gradually, and will be $17,500 for the 2013 tax year. If you’re 50 or older, you may contribute an additional $5,500.

Keep in mind, however, that while federal law sets the guidelines for what’s permissible in 401(k) plans, your employer may set tighter restrictions. Plus, it will take time for the administrators of your plan to implement the changes.

What’s more, there are other federal non-discrimination tests a 401(k) plan must meet, one of which applies to “highly compensated” employees. So if you make more than $115,000 a year, you may not be permitted to contribute as high a percentage of your salary as some of your lower paid colleagues.

For all its tax advantages, the 401(k) is not a penalty-free ride. Pull out money from your account before age 59-1/2, and with few exceptions, you’ll owe income taxes on the amount withdrawn plus an additional 10% penalty.

Also, be aware of your plan’s vesting schedule — the time you’re required to be at the company before you’re allowed to walk away with 100% of your employer matches. Of course, any money you contribute to a 401(k) is yours.

H/T Source: CNN Money

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