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What is a 401(k) & can I take my money out now?

Photo Credit: Bradley Strong

To begin, the 401(k) plan is one of several options for retirement packages. It is a defined contribution plan developed in 1978 and defined in IRS code sections 401(a) and 401(k). Inside these code sections, the IRS defines what a “qualified account” is and provides favorable tax treatment towards both the employee and employer.

For plan participants, the 401(k) benefit is an account, not an investment. One doesn’t go out and investment in their 401(k); they place the investments they make for the purpose of retirement in their 401(k) account. Good examples of investments well-suited for a 401(k) account are company stock, the stock market, mutual funds, and other types of investment choices. Always do your homework or consult an advisor before making investment choices.

Among other limitations, the IRS limits how much you can contribute each year. For 2009, contributions are limited $16,500 for all 401(k) accounts. If you’re 50 years or older, you can elect to “catch up” and contribute an additional $5,500, or a total of $22,000 in 2009. If you make over $110,000 annually, you are considered a highly compensated employee; contact your HR department to make sure you qualify.

Here is a bullet list of advantages:

·         Your contributions are made with pre-taxed salary thereby reducing your income tax.

·         All contributions are allowed to grow free of capital gains and income taxes.

·         Some employers will match the employee contribution up to a certain percentage. For example, your employer allows you to contribute up to 10% of your salary; if they offered a 50% match and you made a 10% contribution, your company match could potentially add another 5% to your overall salary!

·         You can dollar-cost average or create the habit of routinely contributing to your account no matter how the market is performing. By doing so, you buy more shares when the price is low and less shares when the price is high while reducing the overall volatility of your 401(k) portfolio.

·         You have the protection of the ERISA laws, which prevents creditors and predators from raiding your retirement savings in the event you suffer financial challenges.

·         And lastly, you can take it with you when you leave (and not until then)! You have options. You can take the money out. Or, you can roll it over into your new employer’s 401(k) program or your own Traditional IRA.

There is a catch, though, and it’s a pretty big one. You need to leave your savings in a “qualified account” until age 59 ½. Should you withdraw the funds prior to that age, you will pay a 10% penalty in addition to the federal and state taxes owed on the deferred amount withdrawn. (There could also be fees for processing and handling your transaction.) To cut to the chase, you're looking at about $.50 to $.60 on the dollar if you withdraw this money before the age of 59 ½. For example, if you’re account has $250,000 in it and you decide you’re going to withdraw the funds in a lump sum now because you’re age 55 and that’s your “retirement age,” you could be handed a check for $150,000 or less by the time your through! You need to be age 59 ½ to avert the penalty.

A better solution would be to “rollover” the 401(k) account into your own Traditional IRA or your new employer’s plan and wait until you reach the qualifying age of 59 ½. There is the possibility of taking out a loan and petitioning for a hardship, however, I only recommend that option under the most adverse of circumstances. Make sure you consult an advisor to ensure you understand the tax ramifications of your decision BEFORE implementing it, whatever it is.

We’ve covered the main points of the employer-sponsored 401(k) plan and hopefully you have a better idea of what your options are under that plan. If you have a question or comment, please don’t hesitate to post it or contact me directly for further information. Thanks for reading!

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