What are 401(K) plans?

401(K) plans are tax-deferred retirement savings plans for employees. The employer sets them up and each company has a slightly different 401(K). They are part of a family of retirement plans known as "defined contribution" plans - the amount contributed is defined by the employer or the employee. 401(K) gets its name from the section and paragraph of the Internal Revenue Code - section 401, paragraph K.

How does 401(K) work?

When you join a 401(K) plan, you tell your employer how much money you want to contribute to your account. This amount is deducted from your salary before taxes are applied, so you pay less income tax. More importantly, the money is deducted even before you have received it, making it the easiest savings plan to contribute to. Your employer (usually) matches a portion of your contribution. The money is invested by the plan administrator (on your behalf) in mutual funds, bonds, money market accounts, etc. You decide the mix of investments. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take. Since the plan is an incentive for retirement savings, there is one condition: if you withdraw the money before you are 59.5 years old, you will have to pay tax as well as a 10% penalty fine to the IRS.

Why should you invest in a 401(K) plan?

There are several reasons why investing in a 401(K) plan is advantageous to you:

  • The money you contribute is free from Federal and State taxes.
  • Your employer receives tax benefits for contributing to your 401(K) - this is extra money for you
  • There is a range of investment options and an expert does the actual investing according to your directions
  • Any gains and earnings through this investment are also tax deferred.
  • You can take loans and hardship withdrawals from your 401(K) under certain circumstances
  • The money is deducted even before you receive your salary, thus making it easy to stick with regular saving and investing

When to invest in a 401(K)?

It will depend on your company's policy. Many companies require that new employees complete six months to a year of service before they are eligible to participate in the 401(K) plan. Speak to someone in the Human Resources Department of your company to find out how things work.

How much money can you contribute to your 401(K) plan?

You are usually allowed to contribute between 1-20% of your salary into the 401(K). The maximum pre-tax dollar amount is set by law and adjusted for inflation annually. It all depends on the restrictions of the 401(K) plan your company offers. For more information, contact your Human Resources Department.

Can you withdraw or borrow money from your 401(K)?

Remember that the 401(K) plan was devised as an incentive for retirement savings. If you withdraw money from your 401(K) before the age of 59.5, you will be required to pay tax and a 10% penalty fine to the IRS. However, there are certain circumstances under which money can be taken from your account prior to retirement:

  • Loans: Some 401(K) plans allow you to take a loan against the money you have contributed to the plan. Every company will have its own rules for the loan. Usually they require that there is an extreme hardship, such as health problems, financing a home or such other emergency. Check with your Human Resources Department for details.
  • Hardship Distribution: Some plans allow for a withdrawal in extreme hardships - illness or great financial need. Not all plans do this and usually, if this option is used before the age of 59.5 years, a 10% penalty fine is assessed on the withdrawal. You might have to pay the applicable income tax and will most probably not be allowed to participate in the 401(K) plan for six months. Check with your Human Resources Department for details.
  • Distribution upon termination of employment, death or disability: In case of termination of employment, you have the option to take cash distribution of your funds from the 401(K). If you choose this option, 20% of the money may be held for income tax and the 10% penalty fine may be applicable if you are under 59.5 years of age at the time of withdrawal. In case of death or disability, you or your beneficiary can take the distribution. The 20% income tax may apply. If you wish to avoid this taxation, you must invest the money in a qualified retirement plan within 60 days.

What happens to your 401(K) if you change/leave/lose your job?

You have three options:

  • Keep your money in your former employer's 401(K): You have to have a vested amount of at least $5,000 in your account to choose this option. Also, you have to be under the plan's normal retirement age. If your vested account balance is under $5,000, you may be forced by the employer to take a distribution. Speak to your HR Department for details about forced distribution.
  • Roll the money over into a new 401(K): If you choose this option, make sure that the check is written directly to the new 401(K) account. There is no grace period for this option. If the money comes to you before it is placed in the new account, you will be charged the income tax and 10% penalty fine.
  • Cash out: you can withdraw the money in your 401(K). However, if you are under the age of 59.5, the income tax and 10% penalty fine will apply. If you are 55 years or older, you can begin tapping into your 401(K) and the 10% penalty will not apply. It doesn't matter if you left the job or were fired or retired. However, you will still have to pay the income taxes on your withdrawals.

Check with your HR Department for details and specifications for these conditions .

What happens to your 401(K) if your company goes bankrupt?

If your company goes bankrupt or is bought by another company, the contributions made to a 401(K) plan are held in trust by an independent custodian. Your employer does not have access to these funds. So, whatever the circumstances, the money in your 401(K) account remains yours.

What happens to your 401(K) if you leave USA?

Your status (Resident/H1B or other visa/Citizen etc.) in the US at the time of contribution to the 401(K) and at the time of withdrawal is considered. It is best to consult a competent accountant or financial advisor about this matter. You have a few options:

  • At the time of leaving, if the amount vested in your account is more than $5,000, you can leave your 401(K) money in your former employer's plan.
  • You can take the lump-sum payment of the money in your account. You will have to pay the taxes and penalties associated with early withdrawal.
  • You can directly rollover the amount in your 401(K) account into an Individual Retirement Account or IRA. Please remember, your Social Security Number is always valid (whether you live in the US or abroad), however, your finances and investments here are affected by various factors including your status in the US and how often you visit or live in the US among other things. It is best to consult experts in the field before making these important decisions.

401(K) glossary of terms

Defined Contribution Plan: A type of retirement plan that specifies the contributions made to the plan, either as a flat dollar amount or as a percent of compensation.

IRA: An individual retirement annuity or an individual retirement account. A tax-qualified retirement savings vehicle that is maintained by an individual and generally is not sponsored or contributed to by an employer. Depending on your adjusted gross income, you may be able to contribute money to an IRA in addition to the amount you save in your 401k plan.

Qualified Retirement plan: An employee-sponsored retirement plan you may purchase on pre-tax basis which provides tax-deferred earnings.
Rollover: An individual, or nonqualified, retirement plan moved from one trustee to another because of changes in your employment status.

Tax Deferred Investment: An investment where earnings are not taxed as they accumulate. Taxes are deferred or delayed-generally until you receive a distribution. Your contributions to a 401(k) plan or traditional IRA are examples of tax-deferred investments.

Vesting: The "vested" portion of your 401k account is the part that is yours and that cannot be forfeited. To better understand, consider that there are two types of 401k contributions: the contributions you make and the contributions your employer makes (such as "matching" contributions).

Useful Links

  • Website of Profit Sharing/401(k) Council of America (PSCA), a non-profit association of businesses.: www.401k.org
  • Website of American Pensions, Inc., a provider of 401k administrative and investment services. Their 401(K) FAQ is quite useful www.401kfocus.com
  • Dept of Internal Revenue Services (IRS): www.irs.gov

Note: This article is for information purpose only. Path2usa.com or the author is not engaged in rendering legal advice. We are providing you with general 401(k) information. For specific information applicable to you, you should consult a qualified financial advisor /CPA, your employer or a lawyer.