401(k) Plan
Definition
A 401(k) plan is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their pre-tax earnings into individual accounts within the plan. The contributions and any earnings on them are only subject to taxes when withdrawn, typically during retirement. This type of plan is also known as a “Salary Reduction Plan.”
How it Works
Employees can choose to contribute a percentage of their salary to the 401(k) plan. These contributions are made before taxes are calculated, effectively reducing the employee’s taxable income for the year. The funds in a 401(k) account can be invested in a variety of assets including stocks, bonds, and money market instruments. The investment options are usually determined by the employer.
Contribution Limits
- Regular Contribution Limit: As of 2011, the contribution limit for a 401(k) is $16,500, indexed for inflation in subsequent years.
- Catch-Up Contribution: Individuals aged 50 and older are allowed an additional contribution, known as a “catch-up contribution,” which is $5,500 in 2011.
Example
Suppose an employee earns $100,000 annually and decides to contribute 10% of their salary to their 401(k) plan. This means they contribute $10,000 pre-tax into their 401(k). If they are 52 years old, they can also contribute an additional $5,500 as a catch-up contribution, making their total annual contribution $15,500.
Frequently Asked Questions (FAQs)
Q1: Can I change my 401(k) contribution amount? A1: Yes, most 401(k) plans allow participants to change their contribution amounts during certain periods throughout the year.
Q2: What happens if I leave my job? A2: If you leave your job, you typically have several options: leave your 401(k) with your former employer, roll it over into a new employer’s plan, roll it over into an individual retirement account (IRA), or cash out (though this last option has tax implications and potential penalties).
Q3: Are there penalties for early withdrawal? A3: Yes, if you withdraw funds from your 401(k) before age 59½, you may face a 10% early withdrawal penalty in addition to regular income taxes.
Q4: Is there a required minimum distribution (RMD)? A4: Yes, once you reach age 72, you must begin taking required minimum distributions from your 401(k).
Q5: Can I take out a loan from my 401(k)? A5: Some plans allow for loans, but there are specific terms and conditions, including the necessity to repay the loan within a certain time frame to avoid penalties and taxes.
Related Terms
- Roth 401(k): An employer-sponsored retirement plan that allows for after-tax contributions, with tax-free withdrawals in retirement.
- Individual Retirement Account (IRA): A retirement savings account with similar tax benefits to a 401(k), but not employer-sponsored.
- Defined Contribution Plans: Retirement plans where the amount contributed is defined, but the benefit received at retirement depends on investment performance.
Online References
Suggested Books for Further Reading
- “401(k)s & IRAs For Dummies” by Ted Benna and Brenda Watson Newmann
- “The 401(k) Millionaire” by Todd R. Tresidder
- “Get a Financial Life: Personal Finance in Your Twenties and Thirties” by Beth Kobliner
Fundamentals of 401(k) Plan: Retirement Savings Basics Quiz
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