What Is a 401(k) Plan & How Does it Work?

Early 401(k) participation will help to ensure your beachfront retirement plans.

Early 401(k) participation will help to ensure your beachfront retirement plans.

A 401(k) plan is an employer sponsored cash or deferred arrangement -- CODA. The employer's plan must comply with Internal Revenue Code 401(k), so that your pre-tax payroll deductions will qualify for tax-deferred status. To get the most from your retirement planning efforts, you should become familiar with basic 401(k) contribution and election guidelines, determine your investment goals and be aware of the impact that withdrawals will have on the money you have accumulated.

Contributions

Your employer will give you an opportunity to elect or decline to contribute a portion of your pre-tax earnings to the company’s 401(k) plan. By electing to contribute, you are selecting the plan’s deferred arrangement. Your 401(k) qualified contributions are not subject to federal income tax or the income tax for most states. The contributed amount is subject to Social Security and Medicare tax. Some employers will match all or a portion of your contributions -- yes, that translates to free money.

Automatic Enrollment

If you choose to decline, you are selecting the cash arrangement. If you do not make an election to participate or to decline, the IRS permits your employer to design the company’s 401(k) plan in such a way as to automatically enroll you. You will have to actively decline participation to avoid 401(k) pre-tax deductions.

Contribution Limits

The maximum amount that you are allowed to contribute is determined by two factors: the annual maximums that are announced by the Internal Revenue Service and the limit that governs your company's 401(k) plan. The IRS limit is adjusted each year for inflation. Your employer may impose a lower maximum to ensure fairness. In such cases, the lowered rate is based on actual deferral percentage testing to ensure that owners and highly compensated employees do not have an unfair contribution advantage. The IRS limit for 2010 is $16,500. The cost of living adjustment factor did not increase in 2010, so the 2011 maximum is also $16,500.

Catch-up Provision

When you reach the year of your fiftieth birthday, you are allowed to contribute additional amounts toward retirement. The additional amounts are catch-up contributions. The maximum catch-up amount for 2010 and 2011 is $5,500.

Investments

You are responsible for how your contributions are invested. Your employer is required to offer a minimum of three investment options -- this does not include the company’s stock, and according to the Financial Industry Regulatory Authority, the average 401(k) plan offers eight to twelve choices. Take time to understand the choices that are available, so that your selections are based on your goals and the level of risk you are willing to accept. For many 401(k) participants, this is the first foray into investing. If you are automatically enrolled or do not customize your investments, you are placed in the company's default investment option. The default option must meet federal approval.

Rollover

If you are changing employment or retiring, you will need to decide what to do with the funds in your soon-to-be former employer’s 401(k) plan. Your choices include allowing the funds to remain where they are, rolling the funds into the 401(k) plan of your new employer -- if permitted, rolling the funds into an individual retirement account or taking a lump sum withdrawal. If you have not reached age 59 and a half, you will have to pay a 10 percent early withdrawal penalty in addition to paying taxes when taking a lump sum withdrawal.

Hardship Withdrawal

You are permitted to take a hardship withdrawal to purchase or repair your home, to alleviate severe financial difficulties, to pay for medical expenses that cannot be reimbursed, to pay for educational expenses, to pay for funeral expenses or to prevent eviction or foreclosure. If you have not reached age 59 and a half, you may have to pay a 10 percent early withdrawal penalty in addition to paying taxes when making a hardship withdrawal. Your employer is not required to offer a hardship withdrawal.

 

About the Author

Cheryl Frazier is a freelance writer with more than 12 years of business analysis and technical writing experience. She attended the University of California, Irvine and Pepperdine University and has provided business analysis consulting and technical knowledge content to such industries as construction, entertainment, health care, retail and technology.

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