A 401(k) is a plan set up by employers to help employees save for retirement. It has largely replaced traditional pensions. A well-designed 401(k) plan will benefit both employees and employers. It lets employees decide how much to save toward retirement while getting an income tax deduction for contributions, and affords employers a tax deduction for matching contributions. Its investments will grow tax-free until retirement.
Each 401(k) is different. Some allow employee participation immediately, while others have waiting periods for eligibility, sometimes up to two years. Vesting rules, or the time before an employee actually "owns" employer contributions to a 401(k), also vary. About half of all employers have a waiting period, sometimes as much as five or six years, before an employee is vested and can take all funds out if he leaves the company.
To take full advantage of a 401(k), an employee should contribute the maximum, by deferring pay. This not only builds retirement funds, but the deferred money doesn't count as taxable income, although it does count for Social Security taxes. An employee can put up to $17,000 a year into a 401(k), and those age 50 or over are allowed another $5,500 in "catchup" contributions.
Max the Match
The most common employer match for a 401(k) is 50 cents on the dollar, up to 6 percent of total pay. The match will vary by plan, but an employee should contribute at least enough each year to get the full employer match. He can contribute more, up to the personal limit, but at a minimum should get the full employer match.
Consider a Roth Option
An employee also may be able to choose a Roth option, in which taxes are deducted before funds are put into the 401(k). The advantages of this type of 401(k) is that funds are not taxed when withdrawn and the earnings are tax exempt. In general, withdrawals from both types of 401(k) are subject to a penalty before age 59 1/2, or 55 if the employee has left the employer and did not take another job.
An employee can choose to take 401(k) distributions at retirement in a lump sum or in periodic payments, depending on the terms of the specific plan. Distributions from a tax-deferred 401(k) must start at age 70 1/2 and are subject to tax as ordinary income. Roth 401(k) plans are exempt from mandatory withdrawals. Both types of 401(k)s provide for hardship distributions in case of extreme financial difficulty, but hardship definitions vary by plan.
Contributions to 401(k) plans are invested and grow from earnings, and an employee usually has a choice of several investment options. An employee can choose from funds that invest in stocks and bonds, or money market funds for protection of principal. Most plans allow employees to change investment options, so they can start with growth investments and shift to safer vehicles as retirement nears.
Bob Haring has been a news writer and editor for more than 50 years, mostly with the Associated Press and then as executive editor of the Tulsa, Okla. "World." Since retiring he has written freelance stories and a weekly computer security column. Haring holds a Bachelor of Journalism from the University of Missouri.