401k, Roth 401k, Roth IRA and Traditional IRA are popular types of “qualified plans.” The purpose of this post is to help you find a few innovative ideas that you can use to help save for retirement more effectively.
As you read, note the concepts that apply to you to discuss later with your financial and tax advisor. Unfortunately, the tax code is complex and there are many qualified plan rules that can result in penalties when you least expect. Become educated, so that you can ask better questions, while you save and find ways to grow your money wisely.
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What is 401k?
A 401(k) plan is a retirement savings plan offered by many employers that has tax advantages for the saver. It is named after section 401 of the U.S. Internal Revenue Code (IRC). The employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may then match part or all your employee contribution. The employee gets to allocate their money among several investment options, usually among a selection of mutual funds and company stock.
401k plans are easy to get started and help make saving money easy. Your paystub will show the amounts you contributed to your 401k plan, but the funds are drafted from your paycheck before you receive your net pay.
It’s a good thing that you don't see the 401k withdrawals from your lifestyle accounts, like your bank checking account. This out-of-sight-out-of-mind approach to saving is effective because the 401k contributions are there, but they are less noticeable -- creating less stress and more peace of mind still knowing that you are saving for your future. You see the funds in your 401(k) statement or online account when you check those statements occasionally, but that’s separate from your daily, lifestyle money.
How does it work?
• A 401(k) plan is a company-sponsored retirement account to which employees contribute income, while employers may match the employee contributions.
• There are two basic types of 401(k)s—Traditional and Roth—which differ primarily in how they are taxed.
• With a traditional 401(k), employee contributions are pre-tax, meaning they reduce taxable income, but withdrawals are taxed.
• With a Roth 401(k), employee contributions are post-tax : There is no tax deduction in the contribution year, therefore future retirement withdrawals are tax-free.
• Employees can split contributions between both types of plans. • Employers will match only the Traditional 401(k) contributions, not the Roth 401(k) contributions.
Advantages
• Funds are saved with relative ease, because paycheck debits are like forced savings and not noticed in your lifestyle accounts.
• Many companies match a portion of your contribution. In this case, you are receiving extra money from your employer. After set periods, called the vesting schedule, the money officially becomes vested and becomes yours. That's what you want! Of course, you need to stay with the company longer to become fully vested – usually five years. Sometimes this makes leaving your company difficult.
• 401k plan administrative expenses tend to be exceptionally low.
• 401(k) plans often offer loan options up to 50% of the account balance at a reasonable interest rate for up to five years, but these loans must be paid back right away, if you decide to leave the company. Failing to pay back the loan after leaving can lead to penalties and taxes on the deemed withdrawals.
• You may withdraw your contributions to a Roth 401(k) any time without penalty.
• There are six hardship withdrawals allowed before age 59 ½. The list can be found on the IRS website here. These include medical expenses, tuition and first time home purchases. Professional advice is worth the investment to make good decisions about these withdrawals before the funds are taken. For example, the funds withdrawn will be taxed upon withdrawal, even if there is no penalty.
• Some employer plans allow in-service distributions to Traditional Rollover IRAs (Individual Retirement Accounts) or Roth Rollover IRA accounts that you can manage on your own.
Disadvantages
• Excluding hardship withdrawals, Traditional 401(k) funds are not accessible without a 10% penalty until you become 59 ½ years old. That can be a long time to wait, especially if you want to start your own business or need some funds for personal reasons before that age.
• You may withdraw your contributions to a Roth 401(k) any time, but there are restrictions on the investment gains, like with the Traditional 401(k).
• Many savers become lazy with their investment monitoring and management in these plans. Reviewing investments periodically according to your risk tolerance and goals is important.
• Future taxes may be more than they are today, so that the Roth 401k may be more desirable for retirement income.