The 411 on the 401(k)

June 16, 3:21 PMJacksonville Retirement Planning ExaminerBryan Dudones

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What is a 401(k)?

The 401(k) is an employer-sponsored retirement plan named after Section 401(k) of the Internal Revenue Code. Within your company’s 401(k) plan, you can elect to defer a portion of your income to the retirement plan. The amount you defer isn't included in your income and is considered “pre-tax dollars”. Therefore, your federal income tax for that year is reduced. And the deferred portion (along with any investment earnings) isn't taxed until you receive payments from the plan.

When can I contribute?

You can contribute to your employer's 401(k) plan as soon as you are eligible to participate, which are outlined in the terms of the plan. In general, a 401(k) plan can make you wait up to a year before you are allowed to contribute. But many plans don't have a waiting period at all, allowing you to contribute immediately. Some 401(k) plans also provide for automatic enrollment once you've satisfied the plan's eligibility requirements.

How much can I contribute?

In 2009, you can contribute up to $16,500 ($22,000 if you're age 50 or older) to a 401(k) plan. But keep in mind that if you also contribute to another employer's 401(k), 403(b), SIMPLE or SEP IRA plan, your total contributions to all of these plans cannot exceed $16,500 in 2009 ($22,000 if you're age 50 or older). It's up to you to make sure you don't exceed these limits if you contribute to plans of more than one employer.

Can I also contribute to an IRA?

Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Traditional or Roth). You can contribute up to $5,000 to an IRA in 2009, ($6,000 if you're age 50 or older). However, depending on your level of income and tax filing status, your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan.

What about the employer match?

Many employers will match all or part of your contributions (although the current economic climate has directly impacted this benefit at some companies, even the larger ones). Some employers match dollar-for-dollar up to a certain percentage of pay while others match a specified percentage of your contribution. Either way, this is “free” money from your employer. Take advantage of it!

In addition, the company may have a vesting schedule in place that requires you to work for the company for a given length of time before you can collect their matching contributions. "Vesting" means that you own the contributions. The vesting period can be on a graduated scale or a one-time length of service requirement.

What are the tax benefits of contributing to a 401(k) plan?

Probably the biggest benefit of a 401(k) plan is the fact that contributions are made on a pre-tax basis. Those pre-tax contributions mean that you do not pay current income taxes on those dollars (and they could also shift you into a lower tax bracket for the year). In addition to reducing your current tax liability, the money that is contributed to the plan can earn interest and grow tax-deferred. You are only taxed, at the ordinary income rate, when you take withdrawals from the plan.

What happens when I terminate employment?

Generally, you forfeit all contributions that haven't vested. Your personal contributions are always 100% vested. But, as discussed earlier, your employer's matching contributions may not be.

After you terminate employment, you can do a “Direct Rollover” to an IRA tax-free and without any penalties, or move the money to another employer's retirement plan. It is important to note that in some cases, if money is actually withdrawn from the 401(k) account before reaching age 59 ½ (age 55 in certain cases) the IRS will assess a 10% early withdrawal penalty.

What investment choices do I have?

A 401(k) plan allows you to invest money for retirement in several ways. These may include mutual funds that invest in stocks and/or bonds, money markets, company stock or even self-directed brokerage accounts. Unfortunately, many 401(k) plans offer a limited menu of investment options. However, this should not deter you from participating in the plan.

Nothing in this article should be construed as specific investment advice. For investment and tax concerns specific to your needs, please request a personal consultation from your Advisor.