Get answers to three common questions
According to a report by the Employee Benefit Research Institute1, 41.3 percent of employees have less than $10,000 in their 401(k) retirement plans. That's unfortunate, because a 401(k) can be one of the best ways to save for retirement — especially if you have matching employer contributions.
There may be many reasons why someone isn't taking advantage of their 401(k) plan. For some, it could be that they simply don't understand how a 401(k) works and how much they can contribute. Others may look at their plan as a savings account that can be tapped into whenever money gets tight, or think they have to cash their 401(k) out when they leave their current place of employment.
This article answers three common 401(k) questions that we hope will help you better understand how your 401(k) works.
- How much can I contribute?
The Internal Revenue Service (IRS) establishes how much money you can contribute to your 401(k) plan on an annual basis, and provides periodical increases to help keep up with inflation. If you're under age 50, you can contribute a maximum of $18,000 to your 401(k) plan. If you're 50 or older, you can make an additional catch-up contribution of as much as $6,000 — for a total up to $24,000 in 2016. You can check for updated annual contribution limits for various types of 401(k) plans on the IRS website.
- What happens if I leave my job?
If you leave your job, you have several options. The most common is to transfer the money from your employer-sponsored 401(k) into another qualified retirement account. To do this, simply ask your current plan administrator to process a direct rollover of the money in your existing account into your new IRA account. Be sure that they complete a direct rollover and don't issue a check to you. If you receive the money directly as a distribution, you'll be subject to taxes.
Another option is to wait and transfer the money into your new employer's plan. However, your new plan must allow this type of transfer. If this isn't an option, then your third choice is to just leave it with your former employer. However, depending on the size of the balance held in your former plan, you might be required to roll over to an IRA within a specified period of time. It may be best to consider this third option if you need some time to figure out what you want to do with your money.
Note: If you're under age 59 ½, the last thing you want to do is cash out your account. If you do, you'll not only be subject to a 10 percent withdraw penalty, but you'll also be taxed on the entire distribution.2
- When can I take out my money?
As the aforementioned note indicates, you can't take money out of your 401(k) plan prior to age 59 ½ without incurring a penalty and paying taxes. This may seem harsh considering it's your money, but the idea is to set aside money for retirement — not spend it when you need some cash.
There are certain situations in which you are allowed to make non-retirement distributions from a 401(k). However, you still must pay income tax on any money that you take out, and you will be subject to a 10 percent penalty if taken prior to age 59 ½. These “hardship” withdrawals allow you to take out money to pay for things such as higher education costs and buying your first home. You can read more about hardship distributions on the IRS website. You may also have the option of taking out a 401(k) loan. However, if you don't repay the loan within a certain timeframe, it could be counted as a withdrawal and you'll be subject to the 10 percent penalty. It is also important to understand the payback requirements of loans if your employment with the company ends.
It's important that you understand how your 401(k) works in order to maximize your money. Today, this is especially important since Social Security won't be able to fully replace your income when you retire and you'll need to rely on other savings.