How a 401k Retirement Plan Works

With the baby boomers reaching retirement age, it’s eminent the government will face a lot of pressure in caring for them. This will push pensions to the limit and cuts will be made to house the increasing number of retirees resulting to lower gains or forcing retirees to go back to work to sustain a living.

If you have just started working or are approaching retirement, it’s imperative that you prepare for comfortable retirement in time to avoid ending homeless or leaching on your siblings. There are various ways to save for retirement with the most preferred being the 401(k) plan. Others include the 401(a), pension schemes, and investing.

The IRS defines the 401(k) plan as a compensation plan where one can choose to have an employer contribute a percentage of his wages to the 401(k) plan to a pretax basis.

How to contribute money to a 401(k) retirement account

The employer or organization must back up the 401(k) plan, but it’s up to the employee to determine the amount he is willing to contribute without surpassing the provided limit. The limit as of 2011 is at $16500 for those aged bellow 50 years and an additional “catch-up contribution” of $5500 for those above 50 years.

Some employers will match up what you contribute meaning, you will have double the amount you contribute in your account. In such a scenario, the higher you contribute the higher the amount your employer will contribute as well. Others will make profit sharing contribution into your account and this relies on how profitable the company is.

Understanding 401(k) tax deferment and taxation

When you contribute to a 401(k) plan, the contribution, also known as elective contribution, will not be subject to taxation. In simpler terms, these contributions will not appear on your Form 1040 because you do not include them in your Form W-2. The IRS, however, cautions that the contributions are subject to taxation under, federal unemployment, Medicare and social security.

If you withdraw from the 401(k), prior to retirement age (59 ½ yrs), you might be penalized 10% taxation unless the withdrawal, also known as hardship withdrawal, qualifies for exception.

How secure are 401(k) plans?

Since a 401(k) plan makes money from investing either in stocks, bond, mutual funds and other money market instruments, it is subject to economic changes. The government, however, keeps a close eye on 401(k) plans and can regulate where to invest. 

401(k) IRA rollovers and 20% withholding law

If you leave your job and begin working for another company, you get an option of rolling over your 401(k) plan to your new job. This is possible if they have their own 401(k) plan. You can also choose to let your previous employer keep your plan at a fee. If you liquidate any stocks you had from your old company, you must place them in an IRA roll over account in 60 days to avoid taxation. The safest way is not to liquidate anything and do trustee-to-trustee transfer.

Companies are supposed to hold 20% of your 401(k) account when you retire or change jobs for taxation purposes. To avoid the 20% hold, you can directly transfer your 401(k) to your IRA (Individual Retirement Account). This is known as a 100% Direct IRA Rollover.

Sources: – Profit Sharing/401k Council of America – All About 401(k) Plans Ultimate guide to retirement- How does a 401(k) plan work? – Complete 401k Retirement Information