When you start a new job, your boss and co-workers may encourage you to sign up for the company-sponsored 401k. These retirement plans provide you with a fast and easy way to save money for your retirement years. However, the many benefits of 401k plans come with a cost and you should understand how these plans work before you sign away a part of your hard-earned paycheck.
You can reduce your tax burden for the current year by depositing up to 15 percent of your paycheck into your firm's 401k plan. Your employer may or may not offer a company match. Employer's can make matching contributions totaling 6 percent of your base salary in which case you can double your money simply by participating in the plan. However, some companies only offer matching contributions after you have completed a year of service. Check the fine print about the company match and do not assume that your employer will invest in the account.
The money that you invest in a 401k belongs to you but your employer's contributions are subject to vesting schedules. The Internal Revenue Service uses the term "vesting" to describe the process by which funds belonging to your employer gradually become yours. Typically, employer contributions are vested at a rate of 20 percent per year so it takes five years before your entire 401k really belongs to you. If you leave your job before the end of the vesting period, then you can wave goodbye to some or all of your employer's contributions.
The IRS allows your 401k to grow on a tax-deferred basis. However, the agency put safeguards in place to make sure that you only benefit from those tax savings in your retirement years. If you withdraw from the account prior to reaching age 59 1/2, you have to pay income tax on the funds you withdraw as well as a 10 percent penalty tax. Certain exceptions apply to the penalty tax if you become disabled or need money to make a downpayment on a new home, but you cannot avoid paying income tax.
Withdrawal rules prevent easy access to your retirement funds, but you can have temporary access to your money with a 401k loan. The IRS permits employers to add loan provisions in plans but many firms choose not to permit loans. Where permitted, 401k loans cannot exceed the higher of $50,000, or 50 percent of your vested balance. You can repay the loan over the course of five years and the principal and interest are invested back into your own account.
When you buy mutual funds from a broker, you usually have to pay purchase fees known as loads. Your broker may also charge management fees for handling your assets. 401k plans work in the exact same way. You may not realize you are paying fees because the plan custodian deducts the money directly from your account. You should carefully review your plan prospectus when making your investment elections. Choosing the wrong fund could make a big difference in terms of money lost to fees.