Do you have a 401(k) retirement account? Do you understand your account, how it works? Are you putting enough into your account for retirement?
In 2011, about 60% of American households nearing retirement age have 401(k)-type accounts. The first group of workers to widely adopt this 401(k) plans are beginning to retire and their savings just does not seem to be enough. According to a Feb 19, 2011 article in the Wall Street Journal, “the median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement.” This according to a study commissioned by the Journal, and conducted by the Center for Retirement Research at Boston College.
Additionally, the Vanguard Group, one of the biggest providers of 401(k) plans, has changed its advice on how much people should save. Vanguard long advised people to put 9% to 12% of their salaries—including the employer contribution—in their 401(k) plans. The current median amount that people contribute is 9%, counting the employer contribution. However, recently, Vanguard has begun urging people to contribute 12% to 15%, including the employer contribution, because of the stock market’s weak returns and uncertainty about the future of Social Security and Medicare.
401(k) Overview
A 401(k) is a type of retirement savings account, which takes its name from subsection 401(k) of the Internal Revenue Code. 401(k) s were first widely adopted as retirement plans for American workers, beginning in the 1980s. The 401(k) emerged as an alternative to the traditional retirement pension, which was paid by companies and has now pretty much gone away. The 401(k) in general has the effect of shifting the burden for retirement savings to workers themselves – you.
A traditional 401(k) account is funded with pre-tax dollars and, in general, tax must be paid when the original contribution and earnings are withdrawn. Account holders choose to deposit part of their earnings into a 401(k) savings account and not pay income tax on it or the interest the money earns until the money is later withdrawn in retirement creating a tax advantage for the account holder. Often, employers match contributions that workers make to a certain percentage and typically, the 401(k) account is administered by the company. The employee selects from different kinds of investment options in the plan and chooses where the savings will be invested. Many companies’ 401(k) plans also offer the option to purchase the company’s stock. The employee can generally re-allocate money among the investment choices at any time. Additionally, in the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan’s assets will be invested.
Tax Consequences Associated with 401(k)
Depending on whether the plan allows, employees can make contributions to the 401(k) on a pre-tax or after tax basis. With either pre-tax or after-tax contributions, earnings from investments in a 401(k) account are tax deferred. The resulting compounding interest with delayed taxation is a major benefit of the 401(k) plan when held over long periods of time.
For pre-tax contributions, the employee does not pay federal income tax on the amount of current income that he or she defers to a 401(k) account. The employee ultimately pays taxes on the money as the funds are withdrawn at retirement
Withdrawal of Funds
Virtually all employers impose severe restrictions on withdrawals while a person remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before the age of 59½ is subject to an excise tax equal to ten percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction
Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income or subject to the 10% penalty as long as it is paid back in accordance with Internal Revenue Code.
Contribution Limits and Required Minimum Distributions
There is a maximum 401(k) contribution limit that applies to all employee and employer 401(k) contributions in a calendar year. This limit is the section 415 limit, which is the lesser of 100% of the employee’s total pre-tax compensation or $49,000 for 2009 through 2011. Employees who are 50 years old or over at any time during the year are now allowed additional pre-tax catch up contributions of up to $5,500 for 2009, 2010, and 2011. The limit for future “catch up” contributions may also be adjusted for inflation in increments of $500.
A 401(k) account owner must begin making distributions from their accounts by April 1 of the calendar year after turning age 70½ or April 1 of the calendar year after retiring, whichever is later. The amount of distributions is based on life expectancy according to appropriate IRS tables. The only exception to minimum distribution is for people still working once they reach that age, and the current plan they are participating in.
Automatic Enrollment in a 401(k) Plan
Some employers are allowed to automatically enroll their employees in 401(k) plans, requiring employees to actively opt-out if they did not want to participate. Companies offering such automatic 401(k) s must choose a default investment fund and savings rate. Employees who are enrolled automatically will become investors in the default fund at the default rate, although they may select different funds and rates if they choose, or even opt out completely.
Automatic 401(k) s is designed to encourage employees to save and create high participation rates among employees. Therefore, employers can attempt to enroll non-participants as often as once per year, requiring those non-participants to opt out each time if they do not want to participate. Employers may also choose to escalate participants’ default contribution rates, encouraging them to save more.
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