Last month we published a post going over some retirement saving basics, but it’s time to get into some specifics. There are several different options available when it comes to retirement accounts, and today we’ll go over the details of one of the more commonly used options… the 401(k). This is a retirement plan offered by your employer that allows you to deposit money directly from your paycheck.
Here’s how it works…
- Once enrolled in the plan with your employer, you choose the percentage of your weekly salary that you want to deposit. Many employers will match your contribution up to a certain amount, making this option very attractive. Say the company will match up to 3%. That means if you deposit 3%, your employer will bump it up to 6%. If you choose 10%, your employer will make it 13%.
- This money is deposited before being taxed. You will pay the taxes when you make withdrawals years later. More on that later.
Where does this money go?
- This money is invested in a portfolio of mutual funds composed of stocks, bonds, and money market investments. You choose which funds to invest in. You do so based on reports and information that the company provides. With that as your guide, you can decide your level of risk. The riskier investments typically offer the highest potential returns, and less risky funds typically offer lower and steadier returns.
- You can change your investments. For example, you may be more tolerant to risky investments when you are young and have ample time to make up for any losses. However, you may be less tolerant as you age and need to rely on steady returns as you near retirement. Again, this is entirely up to you.
- You will receive statements each quarter that will show you how your funds are performing, and how much money you’re earning on your investments.
How much can I put in?
- The IRS limits how much you can contribute each year. This can change each year. For 2013, the limit is $17,500.
- Some employers will also set their own limits to how much you can contribute. A typical cap is 15% or 20% of salary. The reason for the cap is a complicated law that disallows highly compensated employees contributing at a much higher rate than lower-wage employees within a company.
What if I leave the company? What happens to my 401(k)?
- You have 3 options…
- Cash out: If you withdraw all of the money, you will have to pay taxes on it, and you’ll also be subject to a 10% penalty if you’re under 59 and a half years old.
- Rollover: If you have a new job, you can move your money into that company’s 401(k). If you don’t have a new company, you can open an IRA (Individual Retirement Account) and transfer the money there.
- Leave it alone: If you have more than $5,000 in the account, then your employer must allow you to leave your money there if you choose.
When do I get to withdraw the money?
- When you reach the age of 59 and a half, you can make withdrawals from your 401(k). You will have to pay income tax on your withdrawals. If you take out money at any age younger than 59 and a half, then you will also pay a 10% penalty. However, there are exceptions which will allow early withdrawals…
- If you become permanently disabled.
- If you die and the account is paid to your beneficiary or estate.
- If you make an allowable medical expense deduction (where your medical expenses exceed 7.5 per cent of your adjusted gross income).
- If you are laid off, terminated, or quit your job to take early retirement in the year you turned 55 or later.
- If you have to pay a levy on the 401(k) plan itself.
Retirement plans and the rules surrounding them can be very deep and complex, and they can vary from plan to plan. I’ve tried to cover some of the basic but essential questions here, but you should always consult with your employer or retirement plan advisor with specific questions about your account. Please feel free to add information in the comments if you think we missed anything, or want to share your thoughts with us and your fellow readers.
Also, be sure to check out the Career & Retirement tools available on ConsumerCredit.com