Many employers sponsor tax qualified 401(k) retirement accounts for employees. A 401(k) grows on a tax-deferred basis and these accounts are typically funded with pretax contributions. However, your 401(k) plan may include a provision enabling you to deposit some of your salary into the account on an after tax basis.
You fund your 401(k) by making elective salary deferrals. Your employer may choose to make matching contributions to your account. Your plan may include a Roth option in which case you can make after-tax contributions to your account. While your employer may match your Roth contributions, your employer can only deposit your own salary deferrals into a Roth 401(k) account. Any employer contributions are deposited into your 401(k) on a pretax basis and held separately from your Roth funds.
As of 2012, you can make a maximum annual contribution of $17,000 into a company sponsored 401(k). You can make an additional contribution of $5,500 if you are aged 50 or older. You can deposit some or all of the money into a Roth 401(k), but your total pretax and after-tax deposits to your 401(k) cannot exceed the annual contribution limit. A 401(k) plan including a Roth provision must also include a pretax investment option. Your employer must make the Roth option available to everyone who qualifies to invest in the pretax account.
Withdrawals from your 401(k) are subject to state and federal income tax. Generally, you cannot withdraw funds while still employed. In addition to income tax, you also pay a 10 percent federal tax penalty if you access 401(k) funds before reaching the age of 59 1/2. With a Roth 401(k), you do not have to pay taxes or penalties on withdrawals as long as you keep the account for five years and wait until you have reached the age of 59 1/2 before making withdrawals. If you make a premature withdrawal, your earnings are subject to the same taxes and penalties as pretax 401(k) funds. You do not have to pay taxes on withdrawals of principal from your Roth 401(k).
Both pretax and Roth 401(k) accounts are subject to Required Minimum Distribution rules. This means you must begin making withdrawals from 401(k) accounts in the latter of the year that you retire or the year you turn 70 1/2. The size of your RMDs depends on your age, life expectancy and the balance of your account. If you leave your job you can roll pretax 401(k) funds into a traditional Individual Retirement Account while you can roll Roth cash into a Roth IRA.
- Internal Revenue Service: 401(k) Resource Guide - Plan Sponsors - General Distribution Rules
- Internal Revenue Service: Retirement Plans FAQs on Designated Roth Accounts
- Internal Revenue Service: 401(k) Resource Guide - Plan Participants - Limitation on Elective Deferrals
- Internal Revenue Service: Retirement Plans FAQs Regarding Required Minimum Distributions
- tax forms image by Chad McDermott from Fotolia.com