A 401(K) plan offer many benefits but here are some that you should be aware of.
 Allowing pre tax dollars savings for your retirement. For example, if you earn $60,000/year, contribute 6% of your salary to your 401(k) account and fall in 25% income tax bracket, you’re saving $900 in federal taxes alone. That $900 a year is money that you're investing, rather than giving to Uncle Sam. This saving is even bigger when you consider on average 7% state income taxes. While saving money in taxes is a big benefit, this doesn't mean that you don’t ever pay taxes on your 401(k) balances. Taxes are only delayed and you pay them when you withdraw money from your 401(k) account. You are also responsible for paying taxes on the capital gain that you may have on your contribution. This usually works out great since most people in retirement are in lower tax brackets than they were when employed full time.
Lowering your existing take home pay and thus reducing current tax burden. Remember 401(k) contribution is pre-tax, so money taken out for 401(k) is never considered for regular payroll taxes. As most folks already know, without proper planning, tax burden could be significantly higher and saving money is your 401(k plan is a great way to avoid paying most of your income in taxes.
Ability to loan money against 401(k) balance to handle financial issue is another big plus. While a 401(k) loan may not be the best option to get money for your needs, it is still far better than regular unsecured loans or credit card advances because of the interest rate offered. Remember, your credit score is the key factor in dictating interest rate on your unsecured loans but loans against 401(k) account have no such requirements. You're applying for a loan against your money and thus interest rate is significantly lower. On top of that, money paid in interest charges is deposited in your account so you’re technically paying yourself with this interest.
401(k) plan offers professional fund management and financial advice. Since your money is combined with other participants, total investment pool becomes sizeable and thus attracts top financial firms and managers to take up your 401(k) business. It also spreads the expenses over a bigger group thus lowering your investment expenses as an individual. If you have an investment account with a traditional investment firm, you probably know that investment fees and expenses could eat up most of your return. Also, mutual funds often charge you a front load that could be as high as 6%. A 401(k) account is a great tool in controlling your investment expenses without compromising the quality of the service.
As 401(k) contributions are tax deductible, IRS has added maximum annual limits on the contribution allowed for a 401(k) account. Here is a table that displays the current limits.
| YEAR |
401(k) Contribution Limit |
Catch Up Contribution Limit * |
| 2005 |
$14,000 |
$4,000 |
| 2006 |
$15,000 |
$5,000 |
| 2007 |
$15,500 |
$5,000 |
| 2008 |
$15,500 |
$5,000 |
* Catch up contribution is only applicable for people over the age of 50.
Most employers offer a matching contribution for your 401(k) dollars. Employer matching of your contributions provides you with the possibility of earning some free money. So, if your employer offers you this opportunity, grab it. Maximize your contributions in order to get the best out of your employer's matching. For example, An employer might offer 50% match up to 6% of your salary. What does that mean? Well, in simple mathematical terms, if you make $50,000/year and contribute 6%($3,000) of your salary towards 401(k), your employer will add an additional $1,500(50% of $3,000) to your account. While it may not look like a big amount but if you take a closer look you’ll realize that it is a 3% additional salary raise for just participating in the plan. If your employer offers a dollar-to-dollar matching, from the moment you have put your money in a 401k plan you have already experienced a 100% growth. Bottom line, employer contribution can make a big difference in long run.
Check out this link to understand the difference that your employer contribution can make to your retirement account. One important thing to remember about employer contribution is that they are not always vested right away. Some employers require as much as 5 years of service before employer contribution is 100% vested.
How to use your 401)k) money:
Your 401(k) account enjoys tax free treatment until you retire, so it is important to understand the tax implication in case of certain life events before you actually retire.
If you withdraw your 401(k) money(known as distribution), you’ll pay all the applicable federal and state taxes. You will also be responsible for a 10% early withdrawal penalty. Depending upon your tax bracket and state income tax rate, this could result in as much as 50% of money taken out in taxes and penalties.
However, there are certain exceptions to this 10% early withdrawal penalty rule. You are allowed to withdraw money from your 401(k) account without incurring any penalties in the following cases.
1. You reach an age of 59 ½.
2. You become disabled for some reason and apply for social security disability
3. You have been laid off and you’re at least or above the age of 55.
You have to remember that even in the case of these exceptions, you’re still responsible for federal and state taxes on the money that you withdraw from your 401(k) account. Also, you can’t leave your money in a 401(k) account indefinitely. Under the current regulations by the age of 70 ½ you are required to withdraw money out of the 401k account. An exception is made if you are still employed full time.
One of the way to use money from your 401(k) account is by applying for a loan. Most 401(k) plans allows you to take loan against your 401(k) balance but there is limit on the amount and it can’t exceed 50% of your vested savings. Important thing to remember here is the word “vested”, because if you have a $20,000 401(k) account balance but only $12,000 is vested, you can only get $6,000 in loan and not $10,000. Loan against 401(k) account is not considered distribution and you don’t pay 10% penalty. Just like any other loan, you can select a flexible loan term with your 401(k) account. One of the critical point to remember is the treatment of an outstanding loan if you decide to leave your job. In this case, you will have 30 days to pay back the loan and if you fail to pay it back within 30 days from the date of separation, you’re responsible for 10% penalty as well as taxes since this is now treated as a “distribution”.
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