What You Need to Know About 401Ks

The options can seem complicated when it comes to retirement. Many businesses no longer offer pension funds due to cost. The pension funds allow employers to pay out an income to the retired employee. Most of these funds have been replaced by 401(k) plans.

What Is A 401(k) Plan?

The 401(k) plans were originally created as a supplement to the pension funds. These plans are sponsored by the employer and allocated to various stocks, bonds, and money market investments. According to an online guide published by the Wall Street Journal, 401(k) plans are named for the section of tax code that governs them. Although the employer sponsors the 401(k), you are in control of how your money is invested.

There are two types of 401(k) plans. These include traditional and Roth 401(k). Traditional is seen most often and consists of money not taxed. The withdrawals are taxed when retirement begins. The Roth 401(k) is made of contributions already taxed so no taxes are due at withdrawal.

The majority of employers use an administrator to oversee the investments and help you plan the best strategy for retirement. The following is a list of types of companies that work as administrators:

  • Mutual fund companies (Fidelity, Vanguard, or T.Rowe Price)
  • Brokerage firms (Schwab or Merrill Lynch)
  • Insurance companies (Prudential or MetLife)
  • Payroll companies (ADP or Paychex)

You can make changes in investments no matter which type of administrator your employer chooses. The administrator must provide updates to you periodically.

How Does A 401(k) Plan Work?

The employee chooses what percentage of income will be contributed to the 401(k) plan. This usually ranges between 1% and 6%.This amount is deducted automatically from payroll and transferred to the administrator to be spread out over the stocks, bonds, and money market investments in the employee's portfolio.

The administrator will work with you to implement the best investments for your retirement depending on the percentage being invested, your current age, and your target retirement age. According to CNN Money, investing as much as possible is prudent due to the tax breaks that accompany 401(k) plans. The contributions are made with 'pretax' dollars. This means you do not pay the income taxes on these contributions until you retire.

Many companies will match your contributions. The amount will vary between employers and your contribution may need to be a certain amount to qualify for the matching contribution. The Human Resources department at the company can inform you of the maximum matching contribution. Some companies will only match at 3% or higher and only after you have been there for at least one year.

Vesting refers to the company's contributions in the 401(k) plan and may be determined on the length of time an employee must work for the company before these contributions are matched. The employee's contributions are vested immediately.

There are limits to contributions and these change year-over-year based on inflation. In 2015, the maximum employees can contribute to their 401(k) is $18,000. Employees over the age of 50 may contribute $6,000 more than the maximum. According to the Society for Human Resource Management, the 2016 plan limits will most likely remain the same as the ones for 2015.

If the matching contribution from the employer is in company stock, it is suggested to transfer this stock into diversified investments. No more than 5% to 10% of total assets should be in company stock in case of bankruptcy.

Who Decides How The Money is Invested?

The decision on how the money should be invested falls to the employee. It is advised to spread out the funds over various investments. CNN Money advises to invest mostly in stocks when planning for retirement or another long-term goal. Adding other investments like mutual funds, bonds, or cash can increase the stability of a portfolio. If you are not sure how to invest, the administrator of your 401(k) plan can help you to diversify and optimize your portfolio.

What Happens If I Cash Out Before Retirement?

Cashing out the 401(k) plan can lead to costly penalties and income tax due on the withdrawal. Withdrawing the funds before age 59.5 will result in a 10% early withdrawal penalty. The income taxes due on the withdrawal are taxed at ordinary rates. The IRS may waive the early withdrawal penalty under certain circumstances like payments to avoid foreclosure.

An employee has the option to borrow against the 401(k) total amount. This loan must be repaid with interest even if you change jobs. Taking the loan for an emergency is a better solution than withdrawing early as long as all the repayment requirements are met.

CNN Money reports that when switching jobs, instead of taking the distribution as an early withdrawal, you can:

  • Roll the money over into the new company's plan. Since not all companies do this, it is advised to check with the Human Resources department or the new administrator.
  • Leave the money with the current administrator. If this is permitted, you may be able to keep your money where it is, however you may miss out on certain benefits.
  • Roll the money over into an individual retirement account (IRA) at a financial institution. A rollover IRA allows for tax-deferred growth and may offer more investment options depending on the new administrator.

One caveat about rollover IRAs is not choosing the 'direct rollover' option. If the employee neglects to choose this option, then the former employer can write the check to the employee and deduct taxes from the total amount. It is best to have the former employer write the check directly to the administrator.

How Long Can The 401(k) Account Stay Open?

The 401(k) account can stay open after retirement, however consistent minimum withdrawals are mandatory starting at the age of 70.5 years old.

Opening a 401(k) account with your employer may be one of the best assets you have in preparing for retirement. Inquire with the administrator about the best way to diversify and optimize your portfolio.