A 401(k) plan
is a profit-sharing plan that allows employees to put some of their wages into individual accounts intended as retirement savings. 401(k) plans are 'qualified', meaning that participants enjoy certain automatic tax advantages related to their contributions. Employees make elective contributions (or deferrals), treated as deductions from payroll, to their plan account on a pre-tax basis. Essentially, any wages put into a 401(k) account (up to certain limits) are not considered taxable income for the tax year, and the money is not subject to income tax until it is paid out. 401(k) plans are sponsored by employers, who have the option of making contributions on behalf of employee participants and/or matching all or a portion of employees' own contributions. Almost 80% of American full-time workers have access to a defined contribution plan like a 401(k).
5 things to remember about 401(k) plans
- You may have to pay plan fees which could reduce your overall returns. Just because an employer sponsors a plan, doesn't mean they pay the cost of running it. Plan expenses are often passed on to plan participants.
- Your own contributions (elective deferrals) are always yours. Employers may impose a vesting period on any contributions they make to your plan account, meaning that you might have to satisfy certain conditions before the money would be fully, truly yours. Learn more about vesting here.
- There are limits to your pre-tax contributions. You are only allowed to defer $17,500 worth of income to the plan for 2013 and 2014. Your plan may impose an even lower limit. Also, total contributions (all of yours plus all of your employer's contributions on your behalf) cannot exceed $51,000 for the year.
- You can play catch-up. Even though there are limits on the amount of wages you can contribute pre-tax to the plan each year (see above), those limits are raised as you near retirement age. If you are over 50, you can make up to $5,500 in additional 'catch-up contributions'.
- You can take a loan from your 401(k) plan. Employers are not required to do so, but many offer 401(k) plans which permit participants to take loans against their account balances. Interest typically fluctuates depending on the prime rate. Loans are usually to be paid back within five years (longer if the loan was used to buy a home). Loan proceeds are not considered a distribution and do not trigger an income tax event. Read about the benefits and risks of a 401(k) plan loan here.
When and how you get the money from your 401(k) plan account
Certain events trigger your ability to receive distributions (payouts) of your elective deferrals from your 401(k) plan account. Distributions can begin if you die, are disabled, have a severance from employment, incur financial hardship, or reach age 59 1/2. When you retire or reach age 70 1/2, you have to start receiving mandatory distributions. How and when you receive the money depends on the language of your plan. The plan may call for a single, lump-sum payment, or require installments made over time, or a combination of both. Early (pre 59 1/2) distributions are permitted in certain circumstances. There is an additional tax penalty imposed on early distributions.