What You Need To Know About The Basics Of A 401k Retirement Plan

by Hank Coleman

Your 401k retirement plan is not an emergency fundThe 401k Retirement Plan is still the backbone of most Americans’ retirement planning, and it should be. When combined with the Roth IRA, a 401k Retirement Plan is a great tool to help you accomplish your financial goal of retiring. While there is Social Security still available, the younger generation should not count on much in the way of benefits in 30 or 40 years. Your 401k Retirement Plan will be the main focus in your retirement portfolio. It is important to understand the basics of a 401k Retirement Plan.

Every year, more and more companies are switching from pensions to 401k plans to save costs and put the burden of saving for retirement onto the individual.

Here are some of the basics of a 401k Retirement Plan that you need to know.

The Saving Period

Your 401k Retirement Plan is a defined contribution plan sponsored by your employer. This is the opposite to a SIPP pension in the UK, which is independent of your employer. A 401k is designed to be a savings vehicle for retirement or even THE primary savings tool for your retirement. From within your 401k Retirement Plan, you can typically choose to buy different types of investments that your employer’s plan provides. Most plans offer a wide variety of mutual funds, index funds, and may include an option to purchase company stock.

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Your Employer’s Obligation

The reason it is called a defined contribution plan is because employers have no further obligation to save for your retirement for you like they did with a traditional pension plan. Their obligation ends with ensuring that the program is run correctly (typically by an outsourced company) and then to contribute their matching 401k contribution if you are lucky enough to work for an employer who matches. By this, I mean that most 401k plans offer some type of employer match to the employee’s contribution. Once this match is made, the employer has no other guarantees associated with the account.

Taxes And Your 401k Retirement Plan

One of the great things about a 401k Retirement Plan is that all of the contributions are made with pre-tax money. You can reduce your current taxable income by contributing to your 401k Retirement Plan. However, the 2012 limit to contributions is $17,000, with an additional $5,500 catch-up contribution if you are over the age of 50.

During the period of time that the money is in the 401k Retirement Plan account, it will grow tax deferred until you withdraw it. If you move employers, you typical have four options: roll your current 401k into your new employer’s 401k, roll your 401k into an traditional IRA, leave it in your old employer’s 401k Retirement Plan account, or cash it out. You should avoid cashing it out if at all possible because of the taxes and penalties that you will pay when you do if you are under the age of 59 1/2. You should also have the transfer sent directly to your new employer’s 401k Retirement Plan in order to help you from accidently holding onto the funds too long and qualifying for a disbursement in the IRS’s eyes.

Withdrawals From Your 401k Retirement Plan

Once you reach retirement age and are looking to spend money from your 401k Retirement Plan, you will have to pay taxes on your withdraws. Many 401k Retirement Plans offer the option of continuing to keep your 401k with the company, convert your 401k into an annuity offered by the company, or roll your 401k over into a traditional IRA.

There are many things that contribute to understanding the basics of a 401k Retirement Plan. While they are not an overly complicated investment tool, there are many moving pieces and rules to consider when investing and especially when you withdrawal your funds from the account.

Do you have a 401k Retirement Plan through your employer? Are you contributing enough to capture their matching contribution?

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About Hank Coleman

Hank Coleman is the founder of Money Q&A, an Iraq combat veteran, a Dr. Pepper addict, and a self-proclaimed investing junkie. He has written extensively for many nationally known financial websites and publications. Hank holds a Master’s Degree in Finance and a graduate certificate in personal financial planning. Email him directly at Hank[at]MoneyQandA.com.

Hank Coleman has written 578 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.

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