Traditional 401k FAQs:
What is a 401k?
How does a 401k plan work?
What are the advantages of a 401k plan?
What's the difference between saving money in my company's retirement plan and putting money into a mutual fund or bank account?
What's the difference between a 401k and an IRA?
What if my company goes bankrupt? How is my 401k money protected?
Can I roll my 401k money from my old job into my new company's plan?
Why would I want to rollover my 401(k) funds left with my previous employer?
How does a 401k plan affect my taxes?
How are the earnings in my 401k account taxed?
How much money am I allowed to contribute each year? Does this increase each year?
How much in additional contributions can I make if I'm over 50?
What are company matching contributions?
Are employer contributions included in the annual limit on 401k contributions?
Pre-tax contributions versus after-tax...what's the difference?
How does a 401k plan work?
What are the advantages of a 401k plan?
What's the difference between saving money in my company's retirement plan and putting money into a mutual fund or bank account?
What's the difference between a 401k and an IRA?
What if my company goes bankrupt? How is my 401k money protected?
Can I roll my 401k money from my old job into my new company's plan?
Why would I want to rollover my 401(k) funds left with my previous employer?
How does a 401k plan affect my taxes?
How are the earnings in my 401k account taxed?
How much money am I allowed to contribute each year? Does this increase each year?
How much in additional contributions can I make if I'm over 50?
What are company matching contributions?
Are employer contributions included in the annual limit on 401k contributions?
Pre-tax contributions versus after-tax...what's the difference?
What is a 401k?
A 401(k) is a type of retirement plan that allows employees to save and invest for their own retirement. Through a 401(k), you can authorize your employer to deduct a certain amount of money from your paycheck before taxes are calculated, and to invest it in the 401(k) plan. Your money is invested in investment options that you choose from the ones offered through your company's plan. The federal government established the 401(k) in 1981 with special tax advantages, to encourage people to prepare for retirement. They get their catchy name from the section of the Internal Revenue Code which established them (you guessed it, section 401(k)).
A 401(k) is a type of retirement plan that allows employees to save and invest for their own retirement. Through a 401(k), you can authorize your employer to deduct a certain amount of money from your paycheck before taxes are calculated, and to invest it in the 401(k) plan. Your money is invested in investment options that you choose from the ones offered through your company's plan. The federal government established the 401(k) in 1981 with special tax advantages, to encourage people to prepare for retirement. They get their catchy name from the section of the Internal Revenue Code which established them (you guessed it, section 401(k)).
How does a 401k plan work?
You decide how much money you want deducted from your paycheck and invested during each pay period, up to the legal maximum (the IRS sets an annual dollar limit each year). You also decide how to invest that money, choosing from your plan's different investment options. The money you contribute to your 401(k) account is deducted from your pay before income taxes are taken out. This means that by contributing to a 401(k), you can actually lower the amount you pay each pay period in current taxes. For example, if you earn $1,000 each paycheck, and you contribute, say 5% ($50), you are only taxed on $950. You don't owe income taxes on the money until you withdraw it from the plan, when you could be in a lower tax bracket. Use our 401k Calculators to get an idea of what a 401k plan can do for you.
You decide how much money you want deducted from your paycheck and invested during each pay period, up to the legal maximum (the IRS sets an annual dollar limit each year). You also decide how to invest that money, choosing from your plan's different investment options. The money you contribute to your 401(k) account is deducted from your pay before income taxes are taken out. This means that by contributing to a 401(k), you can actually lower the amount you pay each pay period in current taxes. For example, if you earn $1,000 each paycheck, and you contribute, say 5% ($50), you are only taxed on $950. You don't owe income taxes on the money until you withdraw it from the plan, when you could be in a lower tax bracket. Use our 401k Calculators to get an idea of what a 401k plan can do for you.
What are the advantages of a 401k plan?
There are many advantages to 401(k) plans.
There are many advantages to 401(k) plans.
- The employee is able to contribute to his/her 401(k) with pre-tax money, it reduces the amount of tax they pay out of each pay check.
- All employer contributions and any growth in the investment are able to be tax-free until withdrawal.
- The employee can decide where to invest future contributions and/or current savings, giving much control over the investments to the employee.
- If your company matches your contributions, it's like getting extra money on top of your salary.
- Unlike a pension, all contributions can be moved from one company's plan to the next company's plan, or an IRA, should a participant change jobs.
- Because the program is a personal investment program for your retirement, it is protected by pension (ERISA) laws, which means that the benefits may not be used as security for loans outside the program. This includes the additional protection of the funds from garnishment or attachment by creditors or assigned to anyone else, except in the case of domestic relations court cases dealing with divorce decree or child support orders (QDROs; i.e., qualified domestic relations orders).
- While the 401(k) is similar in nature to an IRA, an IRA won't enjoy any matching company contributions, and personal IRA contributions are subject to much lower limits.
What's the difference between saving money in my company's retirement plan and putting money into a mutual fund or bank account?
Taxes, taxes, taxes! An ordinary savings account or mutual fund doesn't allow you to save on a tax-deferred basis. So in an ordinary savings account, you're saving money that has already been taxed, and you continue to pay tax annually on the earnings of that account, too. The money you contribute to your company's 401(k) retirement plan, however, comes out of your paycheck before taxes are taken out. Plus, you don't pay income tax on the money you contribute to your 401(k) account or on any earnings until you take it out, which is usually at retirement, when you may be in a lower tax bracket. The bottom line: More of your money is working for you instead of going toward taxes. Keep in mind, however, that investing in your company's retirement plan is only a part of a sound retirement saving plan. It is still important to have personal savings aside from your retirement savings, too.
Taxes, taxes, taxes! An ordinary savings account or mutual fund doesn't allow you to save on a tax-deferred basis. So in an ordinary savings account, you're saving money that has already been taxed, and you continue to pay tax annually on the earnings of that account, too. The money you contribute to your company's 401(k) retirement plan, however, comes out of your paycheck before taxes are taken out. Plus, you don't pay income tax on the money you contribute to your 401(k) account or on any earnings until you take it out, which is usually at retirement, when you may be in a lower tax bracket. The bottom line: More of your money is working for you instead of going toward taxes. Keep in mind, however, that investing in your company's retirement plan is only a part of a sound retirement saving plan. It is still important to have personal savings aside from your retirement savings, too.
What's the difference between a 401k and an IRA?
Both offer you ways to invest for retirement. The key difference between the two is the way the Internal Revenue Service views the dollars you contribute. Since your 401(k) contributions are considered deferred compensation, they're not included as income for federal tax purposes on your W-2 form. IRA contributions aren't always fully deductible from your taxable income, and the maximum amount you can contribute each year is generally lower. A 401(k) plan also offers the added advantages of payroll deduction.
Both offer you ways to invest for retirement. The key difference between the two is the way the Internal Revenue Service views the dollars you contribute. Since your 401(k) contributions are considered deferred compensation, they're not included as income for federal tax purposes on your W-2 form. IRA contributions aren't always fully deductible from your taxable income, and the maximum amount you can contribute each year is generally lower. A 401(k) plan also offers the added advantages of payroll deduction.
What if my company goes bankrupt? How is my 401k money protected?
The Employee Retirement Income Security Act (ERISA) of 1974 established guidelines for how money in 401(k) plans is maintained. The upshot of it is that your 401(k) plan account is not considered an asset of your employer-it is held in trust in a separate account for you. This means that your plan money (which includes all your own contributions and all vested company contributions) is not mixed with your company's money. And, your company cannot access your plan money for any purpose related to maintaining its business.
The Employee Retirement Income Security Act (ERISA) of 1974 established guidelines for how money in 401(k) plans is maintained. The upshot of it is that your 401(k) plan account is not considered an asset of your employer-it is held in trust in a separate account for you. This means that your plan money (which includes all your own contributions and all vested company contributions) is not mixed with your company's money. And, your company cannot access your plan money for any purpose related to maintaining its business.
Can I roll my 401k money from my old job into my new company's plan?
Yes, if your new company's plan allows rollovers. If you roll over your 401k money into another company's 401k plan, you maintain the account's tax-deferred status and will not have to pay taxes on your 401k assets until you withdraw money from the plan.
If your new company does not allow rollovers, you have two other options that would allow you to maintain the account's tax-deferred status:
If your vested account balance is $1,000 or more and you're under age 65, you can leave your money where it is -- and taxes won't be due until you withdraw money from the plan.
OR
You can roll over your 401k into a rollover IRA account. If you do a direct rollover, meaning that the money is transferred directly into the new account, you won't owe taxes until you withdraw money from the account.
Yes, if your new company's plan allows rollovers. If you roll over your 401k money into another company's 401k plan, you maintain the account's tax-deferred status and will not have to pay taxes on your 401k assets until you withdraw money from the plan.
If your new company does not allow rollovers, you have two other options that would allow you to maintain the account's tax-deferred status:
If your vested account balance is $1,000 or more and you're under age 65, you can leave your money where it is -- and taxes won't be due until you withdraw money from the plan.
OR
You can roll over your 401k into a rollover IRA account. If you do a direct rollover, meaning that the money is transferred directly into the new account, you won't owe taxes until you withdraw money from the account.
Why would I want to rollover my 401(k) funds left with my previous employer?
Greater control and more investment choices are generally the reason that retirement plan participants roll over their account balances. You may have other reasons, as well.
Greater control and more investment choices are generally the reason that retirement plan participants roll over their account balances. You may have other reasons, as well.
How does a 401k plan affect my taxes?
Current income tax savings are some of the biggest advantages to joining your company's 401(k) plan. The money you contribute to your company 401(k) plan comes out of your pay before income taxes are calculated. This means three important things:
The taxable portion of your withdrawal that is eligible for rollover into an individual retirement account (IRA) or another employer's retirement plan is subject to 20% mandatory federal income tax withholding, unless it is directly rolled over to an IRA or another employer plan. (You may owe more or less when you file your income taxes.) If you are under age 59 1/2, the taxable portion of your withdrawal is also subject to a 10% early withdrawal penalty, unless you qualify for an exception to this rule.
The plan document and current tax laws and regulations will govern in case of a discrepancy. Be sure you understand the tax consequences and your plan's rules for distributions before you initiate a distribution. You may want to consult your tax adviser about your situation.
Current income tax savings are some of the biggest advantages to joining your company's 401(k) plan. The money you contribute to your company 401(k) plan comes out of your pay before income taxes are calculated. This means three important things:
- You lower your current taxable income. For example, if you earn $1,000 each paycheck, and you contribute 5 percent of your pretax pay ($50), you only pay current income tax on $950. That means lower income taxes now.
- More of your money is working for you. Because you haven't paid income tax on that $50, all of it is being invested in your account, instead of some of it going into Uncle Sam's pocket.
- You don't pay income tax on your contributions or any earnings until you withdraw them from the plan, which should be at retirement, when you could be in a lower tax bracket.
The taxable portion of your withdrawal that is eligible for rollover into an individual retirement account (IRA) or another employer's retirement plan is subject to 20% mandatory federal income tax withholding, unless it is directly rolled over to an IRA or another employer plan. (You may owe more or less when you file your income taxes.) If you are under age 59 1/2, the taxable portion of your withdrawal is also subject to a 10% early withdrawal penalty, unless you qualify for an exception to this rule.
The plan document and current tax laws and regulations will govern in case of a discrepancy. Be sure you understand the tax consequences and your plan's rules for distributions before you initiate a distribution. You may want to consult your tax adviser about your situation.
How are the earnings in my 401k account taxed?
Dividends and capital gains reinvested in your company's retirement plan account will not be taxed until you withdraw them (which is ideally at retirement, when you could be in a lower tax bracket). They are taxed as ordinary income. If you withdraw them before age 59½, you may owe a 10 percent early withdrawal penalty.
Dividends and capital gains reinvested in your company's retirement plan account will not be taxed until you withdraw them (which is ideally at retirement, when you could be in a lower tax bracket). They are taxed as ordinary income. If you withdraw them before age 59½, you may owe a 10 percent early withdrawal penalty.
How much money am I allowed to contribute each year? Does this increase each year?
You can have your employer deduct a percentage of your pay (before taxes are calculated) and invest that money into your retirement plan account, up to the amount allowed by your plan. That amount cannot exceed the annual IRS dollar limit which is $15,000 for 2006, as provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. Thereafter, the new tax law increases the maximum amount you can contribute yearly by $500 increments to factor in the effects of inflation. It's important to remember that your employer-sponsored retirement plan(s) may have additional limits. Some plans allow you to contribute on an after-tax basis as well. After-tax contributions also have a maximum limit determined by the IRS.
You can have your employer deduct a percentage of your pay (before taxes are calculated) and invest that money into your retirement plan account, up to the amount allowed by your plan. That amount cannot exceed the annual IRS dollar limit which is $15,000 for 2006, as provided by the Economic Growth and Tax Relief Reconciliation Act of 2001. Thereafter, the new tax law increases the maximum amount you can contribute yearly by $500 increments to factor in the effects of inflation. It's important to remember that your employer-sponsored retirement plan(s) may have additional limits. Some plans allow you to contribute on an after-tax basis as well. After-tax contributions also have a maximum limit determined by the IRS.
How much in additional contributions can I make if I'm over 50?
The additional contribution amount is $5,000 in 2006; thereafter, it increases by $500 annually.
The additional contribution amount is $5,000 in 2006; thereafter, it increases by $500 annually.
What are company matching contributions?
Some companies offer a "match" or "matching contribution" as an incentive to join the company retirement plan. It means that the company will contribute a certain amount to your account (usually between $0.25 and $1.00) for every dollar that you contribute, up to a certain limit. The match formula can vary. To receive the matching contribution, the plan may require that you work a specified number of years. It makes good sense to take advantage of a company match by setting aside the maximum amount required to qualify for a matching contribution. If your employer offers a matching contribution, your savings can grow that much faster.
Some companies offer a "match" or "matching contribution" as an incentive to join the company retirement plan. It means that the company will contribute a certain amount to your account (usually between $0.25 and $1.00) for every dollar that you contribute, up to a certain limit. The match formula can vary. To receive the matching contribution, the plan may require that you work a specified number of years. It makes good sense to take advantage of a company match by setting aside the maximum amount required to qualify for a matching contribution. If your employer offers a matching contribution, your savings can grow that much faster.
Are employer contributions included in the annual limit on 401k contributions?
Employer contributions are subject to different limits than employee contributions. The federal annual limit on pre-tax contributions applies only to your own contributions. In addition to plan limits, you may also be subject to additional contribution limits if you are considered a "highly compensated employee." The Internal Revenue Code limits the amount of money employees and employers may collectively contribute to each employee's plan account. In 2005, according to the Economic Growth and Tax Relief Reconciliation Act of 2001, the maximum is the lesser of 100% of compensation or $43,000.
Employer contributions are subject to different limits than employee contributions. The federal annual limit on pre-tax contributions applies only to your own contributions. In addition to plan limits, you may also be subject to additional contribution limits if you are considered a "highly compensated employee." The Internal Revenue Code limits the amount of money employees and employers may collectively contribute to each employee's plan account. In 2005, according to the Economic Growth and Tax Relief Reconciliation Act of 2001, the maximum is the lesser of 100% of compensation or $43,000.
Pre-tax contributions versus after-tax...what's the difference?
| Pre-tax contributions | After-tax contributions |
| Come out of your pay before | Come out of your pay after |
| Increase your take home pay now | Do not lower your current taxable income |
| Increase your take home pay now | Do not increase your take home pay |
| Are taxed as ordinary income when you take money out of the plan | Are not taxed at withdrawal because you've already paid it--but you do have to pay tax on any earnings |
| Have restrictions on withdrawals before age 59½ to encourage you to save for when you'll need it most: at retirement. If you withdraw before-tax contributions before you reach age 59&frac21;, you pay ordinary income tax and possibly a 10 percent early withdrawal penalty. | Have fewer restrictions on withdrawals before age 59½. If you withdraw from your after-tax savings before you're 59½, you must also withdraw part of the earnings on that money, which is taxable, and may be subject to the 10 percent early withdrawal penalty. * Note: You do not have to withdraw earnings on any money you invested in 1986 or earlier. |