Find out how a 401(k) retirement plan really works.
Money Girl
219 MG 10 Rules About 401(k) Plans You Should Know
Curious how equity compensation can help build employee financial confidence and move your business forward? Tune in to the latest episode of Morgan Stanley at Work's "Invested at Work" podcast, where we explore the power of financial benefits and how they can help your employees in the workplace and beyond. Listen now by visiting morganstandly.com/investedatwork or stream on Apple or Spotify. Because we believe that when employees thrive, your company thrives too. Again, visit morganstandly.com/investedatwork to listen today. Hi, everyone. Welcome back to the MoneyGirl podcast. I'm Laura Adams, the author of the award-winning book "Money Girl's Smart Moves to Grow Rich." You've probably heard of a 401(k). It's the most popular type of retirement plan, and one of the best benefits that a company can offer its workers. But I'm sure you won't be surprised to hear me say that a 401(k) comes with lots of rules and regulations. Being familiar with how a 401(k) really works is the best way to make sure you understand all your options for your retirement money and to stay clear of transactions that could trigger unnecessary taxes and expensive penalties. So that's what we're going to cover in this show. Now back to 401(k)s. A 401(k) and its sister for nonprofit organizations called a 403(b) is a retirement plan that you can participate in through your employer. I'll just be referring to 401(k)s in the show, but the same rules generally apply to 403(b). These plans allow you to elect to have your employer contribute a portion of your paycheck to the account. When you sign up for a 401(k), you receive a menu of investment options to choose from, some of which might be a family of funds like Vanguard, Fidelity, or American funds. You're responsible for picking investments that are most suited for your risk tolerance and retirement objectives. Here are 10 important rules about 401(k) retirement plans that you should know. Rule number one, contributions must come from payroll deductions. If you're used to making contributions to an IRA or to a brokerage account like Betterment from your checking or savings account, it may seem a little strange that you can't contribute to a 401(k) the same way. The only way you can move money into a 401(k) is through direct payroll deductions, which are called elective deferrals. I'm sure you'd agree that this payment arrangement is a clever way to make it easier for you to automatically save for retirement. When money's at a site, it's certainly out of mind. You won't even miss those retirement contributions after a while. Rule number two, there's an annual limit on how much you can contribute. For 2011, the maximum amount you can put in a 401(k) is $16,500. But if you're age 50 or older, you qualify for additional catch-up contributions and can sock away up to $22,000. Even if you have a second job or self-employed, and also have a SEP IRA, for instance, your total contributions to all workplace plans cannot exceed $16,500 or $22,000 for 2011. Rule number three, employers can match your contributions. Besides the fact that 401(k) contributions are automatic, another smart reason to participate in one is that some employers will match what you put in. A typical match might be something like 50% of the first 6% of your salary that you contribute. Here's how that breaks down. If you make $50,000 a year and contribute 6% of that amount, or $3,000 of your own money, your company would kick in 50% or an additional $1,500. It's like getting a raise without having to do any extra work. And the great thing about matching funds is that they don't count toward the annual limits I mentioned. The total for both employee and employer contributions can be as much as 100% of your pay up to $49,000 for 2011. Rule number four, contributions to a traditional 401(k) are tax deductible. Regular or traditional 401(k)s allow you to contribute money on a pre-tax basis. In other words, you don't pay a penny of income tax on the amount you contribute, nor do you pay tax on any investment gains in the account until you take withdrawals from the plan. However, your contributions are still subject to other taxes, including Social Security, Medicare, and federal unemployment. Rule number five, contributions to a Roth 401(k) are not tax deductible. Many employers are adding a Roth feature to their 401(k) plans that allow you to make contributions on an after-tax basis, just like with a Roth IRA. Roth contributions don't give you an upfront tax benefit. However, distributions are completely tax-free. If your Roth mushrooms in value, you could save a small fortune by not having to pay tax on decades of account growth. To find out whether a traditional or a Roth retirement plan is right for you, be sure to listen to my previous show, number 174, called "What's the Difference Between a Traditional and Roth 401(k)? Rule number six, you can also contribute to an IRA. This rule trips up a lot of people because they don't realize that your participation in a 401(k) has no impact on your ability to contribute to an IRA. You can max out both a retirement plan at work and an IRA in the same year. But depending on your income, your ability to deduct contributions to a traditional IRA may be limited if you or your spouse also participate in a retirement plan at work. I give you much more information about this twist in the rules in a recent podcast called "Should You Contribute to Both a 401(k) and an IRA?" which is episode number 216. Rule number seven, when you leave, you can take your 401(k) funds with you. The contributions that you make to a 401(k) are always 100% vested, which means that you own them. It doesn't matter whether you tell the boss to take their job and shove it or whether they escort you out the front door. Your retirement money is safe. However, the money your employer kicks in may be subject to a vesting schedule that could require a number of years of service before you fully own those funds. You can roll over the money from your old 401(k) into a new employer's plan or into an IRA without having to pay any taxes or penalties. For more details, listen to episode number 134, "How to Handle Retirement Rollovers Correctly." I love learning and anything that makes learning easier. If you're a parent and your child needs some homework help, then Ixcel is a right for your family. Ixcel is an online learning program for kids covering math, language arts, science, and social studies. Ixcel has interactive practice problems for topics from pre-K to 12th grade and everything is organized by grade and subject. 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Tune in to the latest episode of Morgan Stanley at Work's Invested at Work podcast where we explore the power of financial benefits and how they can help your employees in the workplace and beyond. Listen now by visiting morganstandley.com/investedatwork or stream on Apple or Spotify because we believe that when employees thrive, your company thrives too. Again, visit morganstandley.com/investedatwork to listen today. 8. Early or Late Withdrawals are penalized. A very important point to understand about a 401k is that it's not anything like a savings account where you can just withdraw money at any time. The IRS prohibits you from withdrawing funds from a retirement account before age 59 and a half, except in extreme cases. And even then, you may still have to pay a 10% early withdrawal penalty. Once you reach age 70 and a half or retire from your company at an older age, you must start taking required minimum distributions or RMDs from your traditional 401k each year or face a steep penalty. Just like with Roth IRAs, there are no required minimum distributions for Roth 401ks since you already pay taxes on your contributions. Rule #9. You may qualify for a hardship distribution. Many, but not all, plans allow you to make hardship withdrawals for certain immediate financial needs, such as preventing foreclosure or paying for medical bills, a funeral or college. If you qualify for a hardship distribution, it's still considered an early withdrawal that's subject to the 10% penalty I mentioned. I covered the topic of taking 401k withdrawals in podcast #190, so I'll refer you to that show for more information. Rule #10. You may be eligible to borrow from your 401k. Some plans allow you to take an interest-bearing loan from your 401k for up to one half of your vested account balance up to $50,000. Since I also covered this topic in a previous podcast called "Should you take a 401k loan?" you can listen to episode 191 for more details. Workplace retirement plans can be complicated because employers have some flexibility in how they design them, but I promise you that they're worth taking the time to figure out because they offer such great savings and tax benefits. The best way to understand specific rules that apply to your situation is to read your 401k's summary plan description document or to ask your plan's administrator for more information. If you like the tips you get in the Money Girl podcast and want to take even more control of your money, I think you'll like my book "Money Girl Smart Moves to Grow Rich." The book tells you what you need to know about money and about retirement accounts without bogging you down with what you don't. It's available at your favorite bookstore in print or is an ebook for your Kindle, Nook, iPad, PC, Mac, or smartphone. You can download two free chapters at smartmovestogrowrich.com. As always, you'll find links to everything I've mentioned in the podcast on the Money Girl section at quickanddirtytips.com. While you're there, be sure to get more money tips by signing up for the free newsletter. Following me on Twitter, my username is Laura Adams with No Space, and joining the Money Girl Facebook page. To learn how you can work with me for one-on-one financial coaching or have me speak to your organization or at your next event, visit smartmovestogrowrich.com. I'm glad you're listening to Ching. That's all for now. Courtesy of Money Girl, your guide to a richer life. Curious how equity compensation can help build employee financial confidence and move your business forward? Tune in to the latest episode of Morgan Stanley at Work's Invested at Work podcast, where we explore the power of financial benefits and how they can help your employees in the workplace and beyond. Listen now by visiting morganstandley.com/investedatwork or stream on Apple or Spotify. Because we believe that when employees thrive, your company thrives too. Again, visit morganstandley.com/investedatwork to listen today.