In simple terms 401(k) plan is the qualified retirement plan and one of your most valuable retirement planning opportunities for US employees.
A defined contribution plan is a retirement plan wherein a certain amount or percentage of money is set aside each year for the benefit of the employee. The benefits are based on the amount contributed and are also affected by income, expenses, gains and loses. Some examples of defined contribution plans include 401(K) plans, 403(b) plans, employee stock ownership plans and profit sharing plan
What is a 401(k) plan?
A 401(k) plan is a type of retirement savings account in the United States of America, which got its name from subsection 401(k) of the Internal Revenue Code (Federal statutory tax law in the United States) or Title 26 of the United States Code (permanent federal laws of the United States). A contributor (employee) can begin to withdraw funds after reaching the age of 59 1/2 years. (See subsection "Withdrawal of funds" below for restrictions before that age.)
401(k) plan were first widely adopted as retirement plans for United states workers, beginning in the 1980s. The 401(k) plan emerged as an alternative to the traditional retirement pension, which was paid by employers or owners. Employer contributions with the 401(k) can vary, but in general the 401(k) had the effect of shifting the burden for retirement savings to workers themselves.
In the year 2011, about 60% of American households nearing retirement age have 401(k) type accounts.
Money that is withdrawn prior to the age of 59½ typically incurs a 10% penalty tax unless a further exception applies. This penalty is on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee's death, the employee's total and permanent disability, separation from service in or after the year the employee reached age 55.
A 401(k) Plan is Employment-Related
You can only participate in a 401(k) plan if your employer allows you to do so. Your employer must both offer a plan and you must be eligible to participate. Therefore, you cannot set up a 401(k) plan on your own. (However, if you work, you can establish an Individual Retirement Account (IRA) privately. If you're self-employed, you'll have other retirement planning options as well.)
How Much Can You Contribute to a 401(k) Plan?
The amount you save in your 401(k) plan is often called your contribution percentage. If your gross pay is $3,000 and you'd like to put $300 of each paycheck into your 401(k) plan, you'll need to indicate a contribution percentage of 10%, since 10% of $3,000 is $300.
There is a maximum limit on the total yearly employee pre-tax or ROTH salary deferral into the plan. This limit, known as the "402(g) limit set by the IRS in the recent past, and over the next few years:
- For 2009: $16,500
- For 2010: $16,500
- For 2011: $16,500
- For 2012: $17,000
- 2013 - plus an index for inflation ($500 increments)
On October 20, 2011, the IRS announced 401k contribution limits for 2012. This means that the 2012 pre-tax contribution limit for 401k plans will be $17,000 up from $16,500 with an index for inflation set at $500 increments.If you are 50 years or older and your employer offers “catch-up” contribution for your 401k, you are eligible to contribute additional amounts up to the maximum contribution limits as follow:
These contributions are designed to help people who got a late start or have been procrastinating on their retirement savings be prepared to retire.
401k Maximum Catch-Up Contribution Limits
- 2004: $3,000
- 2005: $4,000
- 2006: $5,000
- 2007: $5,000
- 2008: $5,000
- 2009: $5,500
- 2010: $5,500
- 2011: $5,500
- 2012: $5,500
- For 2009: $16,500 ($22,000 if age 50 or older)
- For 2010: $16,500 ($22,000 if age 50 or older)
- For 2011: $16,500 ($22,000 if age 50 or older)
- For 2012: $17,000 ($22,500 if age 50 or older)
- Free money from your employer
- Lower taxable income
- Savings and earnings that accumulate without you having to remember to make deposits
- The opportunity to retire and not have to worry about money anymore
D0NT CASH OUT
Don't cash out your 401(k) when changing jobs, no matter how small the balance. This interrupts the flow of compound returns and it's very difficult to make up lost ground over time. Instead, roll over the account to your new employer or a low-cost stand-alone IRA, or leave it in place if it's a good plan.
At the end of 2010, the average 401(k) balance held by a worker in his or her 60s, who had been on the job for between 20 and 30 years, was $159,654, according to the Employee Benefit Research Institute
More companies are shifting responsibility for retirement planning and funding to their workers. Traditional defined benefit pension plans and generous matching arrangements are giving way to employee funded 401(k) plans and cash balance plans. Reasons for the change include company cost cutting, competitive pressures, and a general decline in the length of tenure of employees.