401(K) - Frequently Asked Questions

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401(k) is the most popular retirement planning tool. Most people participate in a employer sponsored retirement plan but few really understand how a 401(k) plan works and what are the important things they should be aware of. Majority of people have questions but there isn't a reliable place to find answers to your questions. Fiscalwealth has worked with top financial advisors and retirement planning specialists to gather some of the common questions and their answers

Here is our list of frequently asked questions that are important to retirement plan investors:

If taxes are withheld from my 401(k) distribution, do I have to include the amount of the distribution as income and do I pay the 10% early withdrawal fee as well?

Yes, even though your plan administrator withheld 20% in federal income taxes, you need to include in your ordinary income the total amount of your 401(k) distribution reported on Form 1099-R. Remember, any kind of distribution from Pensions, Annuities, Retirement on Profit-Sharing Plans, IRAs Insurance Contracts, etc. is considered ordinary income and should be reported on your tax return. In addition, if the distribution occurs before you are age 59 1/2, you may need to pay a 10 percent additional tax on early distributions from qualified retirement plans unless you meet one of the exceptions.

Can I withdraw funds penalty free from my 401(k) plan to purchase my first home?

If you are under the age of 59 1/2, you cannot withdraw funds from your 401(k) plan to purchase your first home without being subject to a 10 percent additional tax on early distributions from qualified retirement plans. However, depending on the rules for your 401(k) plan, you may be able to borrow money from your 401(k) plan to purchase your first home. Your plan administrator should have written information about your particular plan that explains when you can borrow funds from your 401(k) plan as well as other plan rules.

If I switch jobs and take distribution from my old retirement plan, How long do I have to roll over a retirement distribution?

You must complete the rollover by the 60th day following the day on which you receive the distribution. (This 60-day period is extended for the period during which the distribution is in a frozen deposit in a financial institution). The IRS may waive the 60 day requirement where failure to do so would be against equity or good conscience, such as in the event of a casualty, disaster, or other event beyond your reasonable control.

If switching jobs, should I rollover my 401k or switch to an IRA?

It depends on your individual situation. One of the main reasons why you would want to roll into another 401k is if you are offered good investment choices and no maintenance fees. IRAs give you more control of your assets but you will have to either manage it yourself or pay a annual fee. Even worse, you may have to pay higher load fees in you plan to invest in mutual funds. However, with recent popularity of online discount brokers, it is very easy to manage a self directed IRA with some professional advice at no cost. If you are a savvy investor, It is suggested to put your money into a self-directed IRA and then try and contribute as much money as possible into the new job's 401k.

I have been hearing a lot about hardship withdrawals? What exactly are hardship withdrawals?

Under certain circumstances, some companies will allow you to permanently withdraw money from your 401(k), even without leaving your company. It is not recommended because of the tax implications. That's because you'll generally owe income taxes plus a 10% early withdrawal penalty. A company can determine its own definition of "hardship," but many use what are called the "safe harbor rules" which allow withdrawals for the following reasons:

To pay medical expenses
To pay college tuition
To cover funeral expenses
To avoid an eviction or foreclosure

I am changing job. Is it possible to do a IRA rollover from my retirement plan without paying any up front taxes or fees?

Remember, if you ask for a distribution from your existing 401(k) plan, they are required by law to withheld 20% federal tax and sometimes even state tax before sending you the money. Now if you open another IRA account and deposit this money within 60 days from the date of distribution, you technically did a IRA rollover and you shouldn't owe any taxes or penalty. However, your old administrator has already taken out 20% due to rules and that the money you would not recoup until you file your taxes. Once of the easiest way to avoid this withholding is to do what is known "trustee-to-trustee transfer". If you do this, you will not have to pay any taxes. The only fees you would pay would be whatever fees (if any) that your old and/or new investment company may charge you. Trustee-to-trustee transfer requires you to have a new custodian for your rollover IRA before money can be released from the old plan. LEt's take an example. Let's say you work for IBM and Merrill Lynch manages their 401(k) plan. If you leave the company, you can open an IRA account with one of the online discount brokers(let's say Ameritrade) and then call Merrill Lynch to do a Trustee-to-trustee transfer. Merrill lynch will send you a check but it is written out to Ameritrade with your name as a beneficiary. This ensures that money is deposited in the account it was intended for.

What are the advantages to a 401(k) plan?

There are many advantages to 401(k) plans.

The employee is able to contribute to his/her 401(k) with pre-tax money, it reduces the amount of tax they pay out of each pay check.

All employer contributions and any growth in the investment is able to be tax-free until withdrawal.

The employee can decide where to invest future contributions and/or current savings, giving much control over the investments to the employee.

If your employer matches your contributions, it's like getting extra money on top of your salary. Unlike a pension, all contributions can be moved from one company's plan to the next company's plan, or a special IRA, should a participant change jobs.

Because the program is a personal investment program for your retirement, it is protected by pension (ERISA) laws, which means that the benefits may not be used as security for loans outside the program. This includes the additional protection of the funds from garnishment or attachment by creditors or assigned to anyone else, except in the case of domestic relations court cases dealing with divorce decree or child support orders (QDROs; i.e., qualified domestic relations orders).

While the 401(k) is similar in nature to an IRA, an IRA won't enjoy any matching company contributions, and personal IRA contributions are subject to much lower limits.

When do I have access to my 401(k) money?

You can borrow money from your 401(k) account anytime you want as long as it does not exceed 50% of the account value. However, you have to pay this loan back or it will be treated as distribution. Generally speaking, you have to wait until age 59 1/2 to tap your account without getting hit with the 10% early-withdrawal penalty. But if you're age 55 or older and you permanently leave your job, then you can begin tapping it immediately without owing the 10% penalty. This is called the "separated from service" exception. It doesn't matter if you quit, retire or are fired. In fact, you could even begin working someplace else. But remember: Even when the 10% penalty doesn't apply, you'll still owe income taxes on your withdrawals.

How do I convert my 401(k) account to a Roth IRA?

A Roth IRA conversion is a two-step process. You cannot rollover your 401(k) funds directly to a Roth IRA. First, you must do a Rollover IRA. After that, you can transfer your Rollover IRA funds, called a conversion, to a Roth IRA. Caution: You must pay taxes on any money that goes into a Roth IRA. You should also consider your adjusted gross income if you plan to convert to Roth IRA. If you have gross income of $100,000 or more - regardless of whether you're married or single -- you can't do a Roth conversion, either. But that's all set to change in 2010. If the tax laws don't change between now and then, the $100,000 limit on Roth conversions will disappear in 2010, opening the floodgates for anyone who wants to convert their traditional IRAs to Roth IRAs.