What is a 401k?
It is a type of retirement account that differs from other kinds, in that it its funds are provided by the employee, rather than by the employer. Part of the account holder’s earnings can be deposited into the account without that person having to pay any income taxes due on them- that is, as long as the money is kept in that fund. When the funds are withdrawn, however, the money does become taxable. If any of the funds are withdrawn before the holder reaches the age of 59½, they become subject to a 10 percent excise tax. (IRA accounts are completely separate, and will not be covered in this article.)
No one can set up a 401k plan on his own. Some companies automatically enroll their employees in a 402k plan. But others require any spplicant who wishes to invest for retirement to fill out a form- and in many cases, an employee must wait until he has worked for the company for a certain length of time. In the latter case, the applicant indicates what percentage of his paycheck he wants to have placed into the account. There is an upper limit on how much money can be put into the fund; the exact figure varies from one year to the next, and can be further limited by an employer. People over 50 can invest considerably more. There is no deadline for contribution; nor does eligibility for a 401k fund depend on one’s income level.
The amount of money saved on income taxes depends on (1) what tax bracket the holder is in, and (2): how much is contributed. One’s FICA and Medicare tax bills remain the same.
401k plians are very flexible; the participant can change how much he saves and how much he invests any time he wishes to. It is advisable to take advantage of this flexibility, investing more in stocks during one’s early years, and less as one approaches retirement age.
What if the owner of the fund leaves the job that supplies it and works elsewhere? If the new employer offers 401k plans, then the money invested in the old one can simply be transferred (“rolled over”) into a new one, with its tax- deferred status still intact; employers are required by law to allow such a rollover. But the transfer must take place within sixty days to avoid penalties and taxation. If, on the other hand, the new employer does NOT offer 401k plans, the thing to do is transfer the money into an IRA fund.
Early withdrawal (before one reaches the age of 59½) results in a penalty, as mentioned above, except if the money was desperately needed (though taxes can on such a withdrawal can never be avoided). Taxes and penalties can, however, be sidestepped by asking for a loan. After the holder reaches 70½ years, yearly withdrawals become mandatory, the minimum amount being determined by the IRS. The money then becomes subject to taxation.