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Tom
March 13, 2014

What is a 401k?

401k beginners guideA 401(k ) is retirement account tied to your employer. The employer sponsors the plan; if your employer does not provide a 401k option you can't run out to the nearest brokerage firm and open an account. (Self-employed individuals can open a Solo 401k,, but that is still tied to your employer. Your employer is you in that case.)

A 401k account is a tax-deferred retirement account. This allows you to set aside pre-tax income and avoid paying tax on that income today. When you withdraw the funds in retirement you pay tax. The tax-deferred setup lets you greatly reduce your tax burden today and allows the full contribution to grow up until retirement.

401k Rules

Retirement accounts are regulated by the Internal Revenue Code. 401k is actually the 401(k) subsection of the Internal Revenue Code. This means the government sets the rules as to who can use a 401k, how they can contribute, and how the funds are treated leading up to and during retirement.

Contribution Limits

For many retirement accounts there are two levels of contribution. First is the contribution anyone can have. However, if you are age 50 or older you are typically allowed a “catch up” contribution as you near retirement.

The same holds true for 401k accounts. For the 2014 tax year everyone can contribute $17,500 of pre-tax income into a 401k plan.

If you are over age 50 you may also contribute an additional $5,500 bringing your total contribution to $23,000.

Early Withdrawal Rules

Withdrawing from a retirement account early is an expensive proposition especially when you are withdrawing from a tax-deferred account like a 401k.

The government gives you a tax break to contribute to a 401k today. However, there's a catch: you have to keep the funds invested until age 59 and 1/2 or face taxes and penalties.

If you withdraw before age 59 and 1/2 and don't meet an exception that allows you to withdraw early, you end up paying both income tax on the withdrawal as well as a 10% tax penalty. This makes early withdrawals extraordinarily expensive.

Here's an example: a married couple decides to withdraw $30,000 from one of their 401k plans in order to remodel their kitchen. Their income tax bracket is 25% and the withdrawal isn't enough to push them into the 28% bracket.

This is how the math works out on their withdrawal:

  • Withdrawal: $30,000
  • Income Tax Owed: $7,500
  • 10% Tax Penalty Owed: $3,000
  • Total Tax and Penalty: $10,500
  • Net Withdrawal Amount: $19,500

A whopping 35% of their withdrawal is cut out in the form of tax and penalty.

Editor's Tip: If you are considering rolling over your IRA account, to one that is self directed, visit here

Hardship & Other Exception Withdrawal Rules

There's no logical reason to withdraw from a 401k earlier than retirement unless you have no other financial choice.

Thankfully the government does give you some grace here in order to lessen the blow.

Here are the reasons that allow you to avoid the withdrawal penalty.

Of course you must still pay income tax:

  • If you die or become disabled
  • If you retired or quit your job and were over age 55
  • You incurred medical expenses that were greater than 7.5% of your adjusted gross income
  • You were required to withdraw the funds due to divorce or separation
  • You elected to receive your distribution as substantially equal payments over your lifetime

401(k) Rollovers

Leaving your job voluntarily or involuntarily can leave your 401k in a lurch.

Do you leave it there?

Do you take it with you?

What exactly are your options?

Here are your choices:

Leave 401k With Previous Employer

Your first option is to do nothing. Simply leave your 401k with the company that administers your (now) former employer's 401k plan. This is a valid option if you like the investment options and costs with the 401k plan.

Rollover 401k to New Employer 401k

If you aren't keen on your former employer's 401k or your simply want all of your funds in one account you can rollover the old 401k to your new employer's 401k plan. The new plan administrator can help you with the forms needed to perform the rollover.

Rollover 401k to IRA

Lastly, and my personal favorite option, is to rollover the old 401k into an IRA. I prefer this option because 401k plans often don't have the best or most diverse investment options. Additionally, 401k plans are not transparent as to their fees. The administrator gets paid to administer the account, but exactly how is often not spelled out very clearly.

The opposite is true for IRAs. You get to select the brokerage firm you roll the funds into so you get to select the fees and investment options you prefer. If I were looking to rollover an old 401k I would find a broker with low cost index funds from Vanguard, T. Rowe Price, or Fidelity.

Consider rolling over to a gold IRA, get a free information kit

How to Open a 401k

Opening a 401k is pretty simple, thankfully. You open up an account when you do your new hire paperwork. However, you aren't required to start the 401k when you are first hired. Starting your 401k can happen at any time; just fill out the paperwork.

Once the account is setup you make your investment elections.

401k contributions and investment elections

Your 401k is tied to your employment. The idea is to make investing for retirement as simple as possible. Your contributions are automatically deducted from each paycheck.

Where do those contributions go?

When you sign up for your 401k plan you make investment elections based on the available options your company's plan provides. You might elect 50% into an S&P 500 index fund and 50% into a total bond market mutual fund.

For every dollar that is deducted for your paycheck, 50 cents would go to the first fund and the remaining 50 cents would go to the second fund. You can make as many elections as you like, but sticking to total stock, international stock, and bond market mutual funds can provide you diversification in just two or three funds.

401k fees

There are two types of fees associated with your 401k plan: investment expense ratios and plan administration fees.

Investment Expense Ratios

No matter where you invest – a 401k, a Roth IRA, a taxable brokerage account – you are going to have expenses tied to your investments in the form of expense ratios. The industry average is 1%, but you can find high quality index funds for 0.20% or less. That savings of 0.80% or more adds up as the years go on.

Be aware of your 401k plan's investment options and their associated expense ratios. Some plan administrators load up 401ks with expensive mutual funds with just a handful of index fund options. Don't be tricked.

Plan Administration Fees

This is the only downside to 401k plans. There is little clarity into the fees tied to administering the plan. They come out of your invested funds, but few plans offer a clearly worded document explaining how much money the plan takes out of your investments.

401(k) savings calculator

If you have a 401(k) with your current company and they provide some type of company match, it is important to use a tool like a 401(k) that will calculate your savings over time with the company match included. Use our calculator below to determine your earnings over time.

401K Savings Calculator

Benefits of 401(k)

401k plans are one of the easiest ways to get started with retirement.

Let's look at some of the benefits:

  • Tied to your employment so your contributions come out of each check
  • You can get free money from your employer in the form of a match on your invested funds
  • Your contributions are tax-deductible up to a certain income level; this allows your money to grow at a faster pace than if you contributed post-tax dollars. (The flip side is you will pay taxes on the full portfolio when you retire.)

Having a 401(k) plan with your employer could be very beneficial if they offer a generous company match. If they don't, you might want to consider rolling it over to something like a self-directed IRA, which allows you more flexibility over your investments.

Click here to get a free retirement kit and consultation

Image credit – EngineeringDaily.net

About the author 

Tom

Tom is a former accountant turned entrepreneur. He is not a financial adviser but does tend to give a lot of financial advice to his friends and colleagues. He currently runs a small online venture and blogs about his research and experiences.

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