How does a 401(k) plan work?
With a 401(k) plan, you elect either to receive cash payments (wages) from your employer immediately, or defer receipt of a portion of that income to the plan. The amount you defer (called an “elective deferral” or “pretax contribution”) isn’t currently included in your income; it’s made with pretax dollars. Consequently, your federal taxable income (and federal income tax) that year is reduced. And the deferred portion (along with any investment earnings) isn’t taxed to you until you receive payments from the plan.
You may also be able to make Roth contributions to your 401(k) plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there’s no up-front tax benefit, but qualified distributions from a Roth 401(k) account are entirely free from federal income tax.
When can I contribute?
You can contribute to your employer’s 401(k) plan as soon as you’re eligible to participate under the terms of the plan. In general, a 401(k) plan can make you wait up to a year before you’re eligible to contribute. But many plans don’t have a waiting period at all, allowing you to contribute beginning with your first paycheck.
Some 401(k) plans provide for automatic enrollment once you’ve satisfied the plan’s eligibility requirements. For example, the plan might provide that you’ll be automatically enrolled at a 3% pretax contribution rate (or some other percentage) unless you elect a different deferral percentage, or choose not to participate in the plan. This is sometimes called a “negative enrollment” because you haven’t affirmatively elected to participate-- instead you must affirmatively act to change or stop contributions. If you’ve been automatically enrolled in your 401(k) plan, make sure to check that your assigned contribution rate and investments are appropriate for your circumstances.
|Make sure you contribute as much as necessary to get the maximum matching contribution from your employer.
This is essentially free money that can help you reach your retirement goals that much sooner.
How much can I contribute?
There’s an overall cap on your combined pretax and Roth 401(k) contributions. In 2009, you can contribute up to $16,500 of your pay ($22,000 if you’re age 50 or older) to a 401(k) plan. If your plan allows Roth 401(k) contributions, you can split your contribution between pretax and Roth contributions any way you wish. For example, you can make $9,500 of Roth contributions and $7,000 of pretax 401(k) contributions. It’s up to you.
What are the income tax consequences of contributing to a 401(k) plan?
When you make pretax 401(k) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay compared to an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan.
In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax. In general, a distribution from your Roth 401(k) account is qualified only if it satisfies both of the following requirements:
• It’s made after the end of a five-year waiting period
• The payment is made after you turn 59½, become disabled, or die
The five-year waiting period for qualified distributions starts with the year you make your first Roth contribution to the 401(k) plan. For example, if you make your first Roth contribution to your employer’s 401(k) plan in December 2009, your five-year waiting period begins January 1, 2009, and ends on December 31, 2013. Each nonqualified distribution is deemed to consist of a pro-rata portion of your tax-free contributions and taxable earnings.
Should I make pretax or Roth contributions?
Assuming your 401(k) plan allows you to make Roth 401(k) contributions, which option should you choose? It depends on your personal situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you’ll effectively lock in today’s lower tax rates. However, if you think you’ll be in a lower tax bracket when you retire, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.
Whichever you decide--Roth or pretax--make sure you contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you reach your retirement goals that much sooner.
What happens when I terminate employment?
Generally, you forfeit all contributions that haven’t vested. “Vesting” means that you own the contributions. Your contributions, pretax and Roth, are always 100% vested. But your 401(k) plan may require up to six years of service before you fully vest in employer matching contributions (although some plans have a much faster vesting schedule). When you terminate employment, you can generally leave your money in your 401(k) plan until the plan’s normal retirement age (typically age 65), or you can roll your dollars over tax free to an IRA or to another employer’s retirement plan.
Allen A. Shpigel, CRPC®,AWMA
Senior Financial Advisor
180 Interstate North Parkway
Atlanta, GA 30339
(770) 612-0200 x 11
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