At some point in your working life, you’ll be handed a 401k plan packet full of information and investment choices, told to fill things out, and, if you’re lucky, someone might actually explain it all for you.
At least, that’s how it happened for me. Except, a couple of salesmen from the plan provider rushed through it in fifteen minutes.
When you know saving for retirement is important, it’s hard to put your trust in a tool that you don’t entirely understand. Luckily, I knew enough to get by while I researched the rest on my own.
The 401k plan is the staple retirement plan offered by employers these days. Yet, dealing with one can be overwhelming and tricky. Your 401k is more than just another retirement account. It’s your primary savings tool for retirement.
This guide will tell you everything you need to know about the traditional 401k plan, the rules and limits, so you can take full advantage of this employer-provided retirement tool.
There’s more than one type of 401k plan. This guide will cover the traditional 401k plan provided by your employer.
Table of Contents
- What is a 401k
- Contribution Rules
- Rollover Rules
- Withdrawal Rules
What is a 401k Plan?
A 401k plan is a type of retirement account your employer offers that provides some unique benefits similar to a traditional IRA:
- It allows you to set aside a portion of your income to be used at a later date, specifically retirement.
- It allows for tax deferred growth of that retirement savings.
- The amount you set aside is tax-deductible, lowering your taxable income, and tax bill.
That means, the money you put into your 401k is specifically for retirement, is tax-deductible, grows tax-free, and won’t be taxed until you take it out. It will be an important savings tool, if not your primary savings tool, for your retirement goals. Still, that 401k plan is only an account. You’ll need to set up the contribution amount, invest that money, and track it over the years.
How to Set Up Contributions
The first step is setting up your contribution amount. This is the amount you want taken out of each paycheck. You can do this one of two ways:
- A percentage of your income (recommended)
- An exact dollar amount
If you’re not sure, I recommend a percentage (I did 15%). That way, raises, bonuses, or anything else that boosts your income will automatically increase the amount you save. Plus, you won’t have to make changes every time your income increases either.
Once you decide, the money is taken directly out of each paycheck and deposited into your 401k account. From there, the money is invested however you choose.
Pick the Right Investments
Outside of the basic 401k rules, there really is no uniformity between different plans. That is, the investment options offered in your 401k plan might be completely different from your neighbor’s down the block. In fact, there’s a good chance a job change would present you with a new list of investment choices. There is no guarantee those choices will be great either.
The typical 401k plan allows you to invest in mutual funds. A good plan provider will offer several options from different mutual fund categories. The 401k might offer a do it yourself option that allows you to invest in individual stocks, bonds, or other investments too. It might offer your employer’s stock as well.
If you have your contributions set up, then there’s no need to rush into choosing. Take your time, research your options, and then decide on the best investments that fit your retirement goals.
The one thing you need to keep an eye on is fees. These are broken down into two areas:
- Administration fees
- Investment fees
The rules on 401k fees were changed in 2012 to add more transparency to administration fees. This tells you how much your 401k plan provider is charging you. Be aware, the administration fees only cover the management costs. There might be additional fees for investment advice, for instance.
Each mutual fund and ETF offered inside your 401k, has fees, listed as the expense ratio. Depending on your plan, there might be transaction costs too. In both cases, costs matter. The more you spend on fees, the less you have to invest and grow your retirement savings.
A free tool I use to compare and track these fees is Personal Capital. It analyzes your 401k and helps you choose lower cost mutual funds to meet your retirement goals. Keep that in mind when reviewing your 401k plan and choosing investments.
If the fees seem excessive, talk to Human Resources, or whomever made the final decision, and point out the high costs. They benefit as much as you from lower fees. Or, take advantage of an IRA once you’ve maxed out any employer match in your 401k plan. That gives you more control over investment choices and costs. Weigh this option carefully. An IRA alone, probably won’t cover your retirement needs.
401k Contribution Rules
Just like every other tax advantaged retirement plan, the 401k has rules on how much you and your employer can contribute each year.
First, lets deal with your 401k contribution limits. Every year the IRS can make inflation adjustments to the maximum amount allowed. These adjustments are based on the cost of living index. If the index rises high enough, the 401k limits will be increased accordingly.
The table below shows the current 401k contribution limits along with previous year limits.
|Tax Year||Max Contribution
||Max Catch Up Contribution (Age 50+)|
|2016||$18,000||Additional $6,000 ($24,000 total)|
|2015||$18,000||Additional $6,000 ($24,000 total)|
|2014||$17,500||Additional $5,500 ($23,000 total)|
|2013||$17,500||Additional $5,500 ($23,000 total)|
|2012||$17,000||Additional $5,500 ($22,500 total)|
You can only contribute up to the maximum amount each year. For anyone age 50 or older you’re allowed a catch up contribution each year, on top of the maximum limit.
Note: Any amount your employer matches, does not count toward your contribution limit.
Employer Matching Contributions
One of the unique benefits of a 401k plan gives your company the ability to contribute to your retirement too. This money is on top of what you can add each year. Now, not all companies do this. If yours does, its free retirement money. Don’t pass it up.
It’s called “employer match” for a reason. In order to get any employer matching contributions, you first need to contribute money. Each company’s 401k matching plan is different. The typical matching plan is written one of two ways:
- match up to a percentage of your pay – a company might match up to 6% of your pay.
- match a percentage of your contributions – a company might match 50% of your contributions.
You could get a combination of the two. It all about the wording and why you should read everything carefully beforehand. You don’t want to miss out on free money.
Vesting is one tactic companies use to keep employees around for a while. Basically, vesting refers to the amount of your 401k that you own. In this case, it refers to the amount of the employer match that you own. To be clear, you will always own 100% of the money you contribute. You’re company, however, might have a time requirement added to the company match until its 100% yours.
My first 401k offered a match up to 3% of my pay, with a tiered vesting plan. In my example, the match was great, but the tiered vesting plan put a time requirement in place before that company match was mine. I wasn’t fully vested, where I owned 100% of the company match, until after three years. Had I left early, the amount I would have received was tiered based on my length of employment (one-third after one year, two-thirds after two years, and fully vested after three years).
This is something to consider before you leave a company, especially if you’re close to a cutoff date.
For most people, the 401k contribution deadline is the end of the calendar year, December 31.
|Tax Year||Contribution Deadline|
|2016||December 31, 2016|
|2015||December 31, 2015|
|2014||December 31, 2014|
|2013||December 31, 2013|
|2012||December 31, 2012|
There are exceptions. The contribution deadline is the same as your employer’s tax filing deadline, which is based on how the company is legally setup and taxed.
More specifically, for businesses taxed as corporations, there is a deadline of December 31. Partnerships or businesses taxed as a sole proprietor have a deadline of April 15, the same as the tax filing deadine. If you’re not sure how the company is setup, contact your human resource department.
Maxing out 401k every year will put you well on your way to a successful retirement. But what happens if you put in more than the yearly limit? Be careful, you could be hit with a tax.
If you do contribute more than the yearly limit, tell the plan administrator before April 15 of the following year.
For instance, if you exceeded the limit in 2013, you must let the administrator know before April 15, 2014. The plan will pay back the extra amount, plus anything earned on it. The excess amount becomes taxable income again and you’ll pay tax on the earned portion too.
Say you don’t tell the administrator before April 15? You will be taxed twice – once for the year you contributed the excess amount and a second time for the year you remove it. Plus, any earnings on the excess is taxed too.
401k Rollover Rules
Job changes are something many of us deal with over the course of our careers. When you leave your job, you don’t have to leave your 401k behind. You can, but you’ll have to keep track of each plan provider. After a while that can be tedious.
The better choice is a 401k rollover. It allows you to take your retirement savings with you, so you have more control over your money. There are several rollover options available to you:
- Rollover to the new employer’s 401k
- Rollover to a traditional IRA
- Rollover to a Roth IRA (with a Roth conversion)
So which is best? Here’s the short and sweet version. Unless your new employer’s plan is great, 99% of the time you’ll be better off rolling your 401k into a traditional IRA. This gives you the most control over the money and costs.
You’ll need to check your new employer’s 401k before deciding. That means covering much of what was previously highlighted. A place to start is with the 401k fees and investment choices. If the investments look suspect or the fees seem high, rollover your 401k to a traditional IRA.
Direct Rollover – The Best Way
Now that you know where to roll your old 401k, the easiest, most convenient, and stress free way to do it is with a direct rollover. A direct rollover will move the money from your old 401k account directly to another retirement account. This way you won’t to have to worry about withdrawal penalties, withholding, or taxes.
Before starting, contact the old plan administrator and find out all the information they need to make the direct rollover as smooth as possible.
If you’re doing a rollover to a new 401k, talk to the new plan administrator to get things setup. There will be some paperwork to fill out and they will take care of the rest.
For a rollover to an IRA, open a rollover IRA account first, so you have some place to transfer the funds. Make sure you choose a broker or bank that will help you through the process. I used TD Ameritrade and it went smoothly, but there are several online brokers to choose from.
The alternative, indirect rollover, can be costly. With an indirect rollover, you’re 401k funds are sent to you as a check , minus a 20% withholding. It’s up to you to deposit that money in another retirement account within 60 days. Plus, you need to cover the 20% withholding out of your own pocket. If you don’t, any money not deposited in time is hit with the early withdrawal penalty and taxed as income.
Whatever you do, avoid an indirect rollover at all costs. If you can’t, make sure you can cover the 20% withholding before starting the rollover. Trust me, I made this mistake once and will never do it again.
401k Withdrawal Rules
At some point you’ll need to take that money out. If all goes well, that won’t happen until you retire. At that point, most people will opt for a 401k rollover to an IRA, as discussed above. That said, there are exceptions to sticking with your 401k plan. The 401k withdrawal rules are very specific about when you can take money out, the reasons why, and what happens if you take money out too early.
Officially, normal 401k distributions can begin at age 59½. Of course, you don’t have to start taking money out at that time. You can continue to work and contribute to your 401k plan or maybe your retirement plan doesn’t call for it yet. Either way, by that point you should have an idea of how much you’ll need in retirement and when you’ll need it.
Required Minimum Distributions
You won’t be able to sit on that money indefinitely. Eventually, the rules require you to start taking minimum withdrawals at age 70½. The only exception is if you haven’t retired and are still working.
In either case, you’re required minimum distributions (RMDs) must start by April 1st of the year you turn 70½ or by April 1st of the year after you retire, whichever is later. After that first year, all RMDs must be made by December 31st of each year.
Here’s a quick example. Say you turned 70½ in 2013. You would have to take your first minimum distribution for the 2013 tax year by April 1, 2014. After that, you would take your minimum distribution for the 2014 tax year by December 31, 2014.
Weigh your tax obligations carefully when taking that first minimum distribution. That money is taxed. You don’t want to take two RMDs that first year and get hit with a big tax bill.
What happens if you don’t take the minimum out? The IRS has rules in place that penalize you for missing a RMD. There is a 50% penalty on the amount you should have withdrawn, but didn’t. In others words, you’re better off taking the RMD each year and paying taxes on it, then paying the penalty.
Early Withdrawal Penalty
The idea of a retirement account is simple. The money goes in and stays there until retirement. Of course, the IRS has rules in place to make sure we don’t touch that money too early. The 10% early withdrawal penalty is meant to do just that. Any money withdrawn before age 59½ is hit with the early withdrawal penalty. On top of that, the money is taxed at your marginal income tax rate.
There are a few exceptions to the early withdrawal penalty:
- Make substantially equal periodic payments (SEPP) through the rule 72t distribution
- Upon separation of employment on or after the age of 55
The limited exceptions are one reason many choose to rollover 401k funds into an IRA. Three of these four exceptions are also covered by IRAs (IRA early withdrawal exceptions also include first time homebuyers, medical expenses, and higher education expenses).
On or After Age 55 Exception
However, the one big 401k exception is the separation from employment on or after age 55. It’s the one advantage of sticking with a 401k since it’s not offered with an IRA. If you see your job coming to an end before age 59½, you can withdraw money from your 401k penalty free if you are 55 or older. Plus, you won’t be tied down by the 72t distribution rules.
That’s not all, there are a few exceptions that fall under the hardship rule. In order to meet the hardship rule, these exceptions must be an immediate and heavy financial need and the withdrawal must be necessary to cover the financial need:
- Used to cover medical expenses
- Used for the purchase or repair of a residence
- Used to prevent eviction or foreclosure from said residence
- Used to cover education expenses
In fact, each 401k will have different hardship rules in place, if any. To be clear, don’t expect anything if you have money lying around somewhere else or assets you can sell to cover your financial burden.
You should dig through that 401k info packet or talk to the plan provider for more details. To get around this, your employer might allow 401k loans.
A 401k loan is exactly as it sounds. It’s a loan made by your retirement account to you, that must be repaid in a specific amount of time, with interest. Yes, you do get charged interest on a 401k loan. Though, the interest is paid to your 401k account.
Before you start borrowing from your 401k, understand why you put the money there in the first place. There are alternative savings tools available for emergencies, homes, education, etc. Don’t pilfer your retirement unless it’s a last resort.
Here are a few other general rules you might find:
- Loan must be repaid in 5 years.
- Maximum loan amount of the lesser of 50% of the vested balance or $50,000.
- If you leave your job, the loan must be repaid in 60 days.
Understand that if you fail to repay the loan in time, the unpaid portion will be hit with a 10% early withdrawal penalty and taxed as income. Not all employers allow 401k loans. Each employer can set the rules around borrowing from your 401k. It’s a good idea to check with the plan administrator first before borrowing anything from your 401k.