Understanding the 401(k) Plan

A 401(k) plan is an employer-sponsored retirement savings plan that offers you significant tax benefits. Here’s how it works…

You contribute to the plan via pretax payroll deductions. Pretax means that your contributions are deducted from your pay, and transferred to the 401(k) plan, before federal (and most state) income taxes are calculated. This reduces your current taxable income because you don’t pay income taxes on the dollars you contribute–or any investment gains on your contributions–until you start making withdrawals (”distributions”) from the account during retirement.

For example, let’s say Riley earns $30,000 annually. She contributes $4,000 of her pay to her employer’s 401(k) plan on a pretax basis. As a result, Riley’s taxable income is now only $26,000. She isn’t taxed on her contributions ($4,000), or any investment earnings, until she receives a distribution from the plan.

What’s the Deal on the Roth 401k?
Due to recent tax law changes, a new option is appearing on the benefits sheet for many employees: The Roth 401k. The difference is that Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. As a result, unlike pretax contributions to a traditional 401(k) plan, there is no up-front tax benefit–your contributions are deducted from your pay and transferred to the plan after taxes are calculated. However, distributions from your Roth 401(k) account are entirely federal-tax free if the distribution is qualified, as discussed below.

Many 401(k) plans let you direct the investment of your 401(k) plan account. Your employer will provide a menu of investment options (for example, a family of mutual funds). But it’s your responsibility to choose the investments most suitable for your retirement objectives.

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 via payroll deduction 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 percent pretax contribution rate 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.

How Much Can I Contribute?
There’s an overall cap on your combined pretax and Roth 401(k) contributions. In 2007, you can contribute up to $15,500 ($20,500 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 $8,000 of Roth contributions and $7,500 of pretax 401(k) contributions.

But keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans–both pretax and Roth–can’t exceed $15,500 in 2007 ($20,500 if you’re age 50 or older). In order to escape IRS penalties, it’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer.

Can I Also Contribute to an IRA in the Same Year?
Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $4,000 to an IRA in 2007 ($5,000 if you’re age 50 or older). But, depending on your salary level, your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan.

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 2006, your five-year waiting period begins January 1, 2006, and ends on December 31, 2010.

What About Employer Contributions?
Employers don’t have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer’s contributions are always made on a pretax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are always taxable to you when you receive a distribution from the plan.

Which Should I Choose: 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 qualified 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 My Employment Ends?
When you (or your employer) terminate employment, you generally forfeit all contributions that have not yet
vested. Vesting means that you own the contributions. All of your contributions, pretax and Roth, are always 100 percent vested. But your 401(k) plan may require up to 6 years of service before you fully vest the employer’s 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 into an IRA or into another employer’s retirement plan.

What Else Do I Need to Know?
Payroll deductions can make saving for retirement easier. The money is “out of sight, out of mind.”

• You may be eligible to borrow up to one half of your vested 401(k) account (to a maximum of $50,000) if you need the money.
• You may also be able to make a hardship withdrawal if you have an immediate and heavy financial need. But this should be a last resort–hardship distributions are taxable to you (except for your Roth after-tax contributions), and you may be suspended from plan participation for 6 months or more.
• If you receive a distribution from your 401(k) plan before you turn 59½, the taxable portion may be subject to a 10 percent early distribution penalty unless an exception applies.
• Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts contributed to the 401(k) plan.
• Your assets are fully protected in the event of your, or your employer’s, bankruptcy.