What is a 401k
A 401K plan is an employer sponsored retirement plan designed to take advantage of section 401K of the federal income tax code. This law allows employers to make tax deferred contributions to employees’ retirement accounts. The advantage to this arrangement is that both the employee and employer can deduct the contribution from their taxable income.
The difference between a 401K and an IRA is that the employer makes contributions to it. Unlike IRAs, 401Ks are usually administered by the employer which is why the have to be rolled over when a person switches jobs. As with an IRA, an employee can use the 401K as a savings account or invest the funds in it in mutual funds and other equities.
Restrictions to 401K Plans
The income tax code puts quite a few restrictions on 401K plans, the size of contributions is usually limited to $2,000 a year and a person must start withdrawing funds at age 70½. There are restrictions on who can take advantage of 401K plans, persons in higher tax brackets are usually barred from using them.
The biggest restriction to 401K plans is the penalties for withdrawing funds before age 59½. A person who does will be charged normal income tax on that money and a 10% tax penalty. That means it is never a good idea for people to put funds they might need in the near future in a 401K plan.
In some cases it is possible to take a hardship distribution without paying a tax penalty. A hardship distribution will have to be allowed by the terms of the plan and its amount is usually restricted to the amount of employee contributions.
Rolling Over 401K Plans
The biggest drawback to 401K plans is that you cannot take them with you when you leave a job. If you want to avoid the 10% tax penalty you will have to roll the funds over into an IRA, an annuity or another 401K plan. To rollover means you simply move the funds into another tax deferred account or investment. Rolling it over preserves the tax deferred benefits and keeps the IRS from counting that money as part of your taxable income.
In most cases, persons roll 401K plans over into Individual Retirement Accounts which provide the same advantages. There are some cases in which a person should rollover into annuity which is also tax deferred. There is no limit to the amount of funds you can invest in annuities so you can keep your tax deferred investment even if you have reached the contribution limits on your IRA or 401K.
A deferred annuity can be used to keep making contributions after the limits are reached. Annuities are an insured investment so the funds in them can be safer than in a 401K.
401K Myths
There are some myths about 401Ks the first is that 401Ks are tax free. That is not true they are tax-deferred which means taxes will have to be paid sooner or later. The second myth is that 401Ks are guaranteed investments – that is not true, instead 401Ks can be used to invest funds in guaranteed or insured investments such as annuities. They can also be used to invest in mutual funds, stocks and other vehicles that can be subject to market losses. Therefore a person has to be very careful when choosing 401K investments because they can lose value.
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Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about finance topics like annuities, insurance, investment, and retirement.
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