Investing in a 401K Plan

Hi guyz, this is a continuation of tax shelters I started off here: Tax Shelters (IRA),where I wrote about IRA’s. Now I am going to look into another investment tool that can be used as a tax shelter: 401k plan. A 401k is a retirement plan fairly similar to the traditional IRA. A 401k is a retirement plan that is not taxed from investment until withdrawal. Contributions to an employee’s 401(k) plan are made from the employee’s salary before taxes.

Defer Tax with 401k plan

Participant’s contributions do not count as taxable income in the year received. 401k plan is a big opposition to pensions in the United States because it has been replacing pensions in more recent years and gradually rising to become the more preferred retirement plan. A 401k plan is sponsored by an employer and it is known as a defined contribution plan. A 401k plan avails employees to invest without paying taxes on their investments until withdrawal. 401k plans are deducted from the source and are not used to compute income taxes for employees.

Participation in a 401k plan depends on the eligibility requirement by the employer. Some employers may require you work for a certain period before you may begin making contributions to your 401k . Others may have no such restrictions, and would allow you make contributions almost immediately.

The beautiful thing about the 401k plan for employees is the option of an employer matching program. Although it is not mandatory for a company to offer contributions to an employee’s 401k plan, some employers choose to assist their employees by contributing to their 401k plan. The employer matching program is when the employer matches the 401k contribution of its employees; although there are some limits on the amount the employer can contribute towards the 401k of the employee.

The most common matching program is 100% of the first 6%. This simply means that an employer contributes the equivalent contribution the employee makes towards his 401k plan to a limit of 6% of the gross pay of the employee. The programs states that once the employer contributes 6% of their gross pay, the employer’s contribution stop until the following year. If the employee contributes below 6% of his gross pay, for example 4% then the employee forgoes the additional compensation (2%).

Example: An employee whose annual gross pay is $100,000, and contributes $6000 towards his 401k would equally receive the same $6,000 employer contribution. If the employee decides to contribute $8,000 that year, he would still not receive more than $6,000 employer contribution. If on the other hand he contributes $4000 towards his 401k plan (4%), his employer matches it by contributing the same $4,000, but the $2,000 additional contribution which his employer could have made would be foregone.

The IRS sets a maximum amount you can contribute to your 401k plan. As at 2015, the limit is $18,000. The catch up participant limit for age 50 and older is $6000. The annual defined contribution limit from all sources is $53,000, and for those aged 50 or older, the annual defined contribution limit from all sources is $59,000.

For 401k plans with employer match, some employers may require that employees work with them for at least a specified number of years, for example 3 years. If the employee leaves before he reaches three years with his employer, he might not get to keep the employer match to his 401k plan. This is called vesting. This occurs over time, for example 25% in a year, or at once after three or four years. When the 401k is fully vested, it means you can take the company match with you by the time you part ways with your job. Withdrawal from the 401k plan before attaining the age of 59.5 years faces similar penalties with that of early withdrawal from an IRA. If you withdraw your money at an age less than 59.5 yrs., you pay the federal and state taxes, alongside a 10% penalty. There are some exceptions to this, they include:

Death benefits i.e. withdrawal upon the death of the participant, by his next of kin
Getting to the age of 50 or over retired or without a job
Paid for medical expenses exceeding 10% of your gross income
Distributions of dividends from an Employee Stock Ownership Plan
Home buyers with the exception that you do not own a home in the previous two years, and only a maximum of $10,000 qualifies for an exemption of early distribution taxes.

Recommended Readings

Twila Slesnick., IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out

Dale Rogers., Craig Rogers., How to Build, Protect and Maintain Your 401(k) Plan: Strategies & Tactics (Trade Secrets)