Have you been busy going through the daily grind of life?? In this cycle, have you put a thought aside for your retirement? Your earning ability and your health will be different after you retire. Therefore, it makes financial sense to put aside a part of your present-day income to be used as savings for your future after you retire.
Retirement should be considered a partial stop to your career or an active life. Retirement is often known as the second inning, as life allows us to restart and pursue things we never had time for in our busy schedules! And for that, financial security is a must. It makes financial sense when we plan our finances so that even after retiring from our careers, we are not financially dependent on anyone and can live life to the fullest. Dependency on a family member or even the spouse can often be detrimental to our self-respect and disrupt a healthy balance that is shared with family members.
The good news is that most employers in the United States of America offer retirement savings plans called 401(K), a popular savings plan. The name sounds unusual for a retirement plan. Indeed, it is an unusual name for a retirement plan because it is a numbered section of the Internal Revenue Code of the United States. Whoever signs up for a 401(K) with their employer allows a certain determined amount to be deducted from their paycheck before tax deduction on income. The amount that is deducted is deposited into an Investment Savings Account. The organization you are currently employed with can either match the amount you have contributed towards the 401(K) account or make a part contribution. For example, if you have set aside $100 towards your Retirement Savings, your employer may contribute equally, that is, $100, or choose to deposit $75. This proportion is left to the choice of the employer, who usually chooses to contribute $0.50 or a dollar for every dollar you contribute.
In a 401 (K) Retirement savings account, your money is routed into various investment options, most of which are mutual funds.
Types of 401(K) Retirement Savings Accounts:
Your employer can offer two types of 401(K) accounts. A Traditional 401(K) and a Roth 401(K) are categorized based on how they are taxed.
The Traditional 401 (K) gives you a tax break as the contributions you make towards the account are deducted from your salary, which is taxable income. Though this relief is temporary, the amount is taxable when you withdraw from your retirement account.
The Roth 401 (K) account is a tax-free option that only very few employers offer. The contribution to 401 (K) is arrived at after the applicable taxes have been paid from your salary. Hence, when you withdraw from your retirement account, you will not be taxed as you have already paid your share of the income tax.
What is the limitation on contribution towards my retirement savings through 401 (K)?
Keeping rising inflation in mind, the individual limit for contributing towards retirement savings has been enhanced. Per the revised rates, individuals under 50 can contribute up to $23000 ($22500 earlier), and those above 50 can contribute up to $30500 ($20000 earlier). A combined limit is also in place for employer and employee contributions not exceeding $69000 for employees under 50 and $76500 for employees over 50. The US government also intends to make it mandatory from 2025 for employers to ensure their employees are enrolled in 401 (K) and 403 (B) plans. The minimum automatic contribution has been fixed at 3%, which will be increased by 1% annually until it reaches 10%. However, this threshold should be at most 15%.
How is the money I invest in a 401(K) used?
Your plan administrator provides different investment options for utilizing your 401 (K) funds. You could choose between mutual, index, and exchange-traded funds/. You also decide the proportion in which your funds are to be invested. Most plans automatically enroll 401 (K) account holders in a target-date fund, a mutual fund with a good combination of bonds and stocks. The proportion in which these bonds and stocks are invested usually depends on your age and your expected year of retirement. If you are young, the number of stocks in your portfolio will likely increase.
Just because you have been automatically enrolled in a target fund does not mean you have to stick to the same. One can always switch to a different type of investment that aligns more with their goals. If you need help figuring out where to invest your money, you can always seek the help of a financial advisor.
What happens to my 401 (K) if and when I switch companies or lose my job?
The answer to that question is that there are multiple options for you to consider when this happens! Switching companies is part and parcel of one’s career growth, and when you change your job, you can either leave your old 401 (K) with your previous employer or move it to your current employer. To move your old plan to your current employer, find out if a trustee-to-trustee transfer is possible. If you leave your plan with your old employer, they may require you to withdraw your funds within a prescribed period after leaving your job. If there is no such requirement, this would still mean that you have to keep an account of multiple 401 (K)’s.
If your 401(K) balance is less than $1000, your employer can give you a cheque for that amount. After you encash the cheque, there is a 60-day grace period before the amount is invested in an IRA or your new employer’s 401 (K). If the balance is between $1000 and $5000, your administrator can pay the balance to an IRA.
Other than leaving your previous 401 (K) with your old or new employer, moving the money to an IRA by initiating a transfer is possible. Again, one must remember that Traditional 401 (Ks) should go to a traditional IRA and Roth 401 (Ks) in a Roth IRA.
Is withdrawal of funds from a 401 (K) account complicated?
Until you reach the age of 59.5 years, revenue rules are in place to discourage you from withdrawing funds from your account, as the funds were intended as your retirement savings. It is why early withdrawals are subjected to a 10% tax penalty of the amount you withdrew, along with a 20% mandatory income tax cut.
After you turn 59.5 years old, you can begin to accept distributions from your account, but a withdrawal is possible after you turn 72 as Required Minimum Distributions (RMDs). The RMD varies depending on your age and the funds available in the account. Withdrawal from an RMD can be made in one go or multiple transactions throughout the year.
Is there a way I can avoid the early penalty on 401(K)’s:
As a thumb rule, you are generally discouraged from withdrawing from your 401 (K) savings. However, certain exceptions allow early withdrawals without a penalty before you reach the age of 59.5 years.
Medical bills that are costing beyond 10% of your income.
Specific Military Service
A disability of a permanent nature
A change of job or if you quit/resign from your job at the age of 55 or more
Based on a QDRO (Qualified Domestic Retirement Order) issued by a court. In this case, the distribution to the ex-spouse can be moved to an IRA to delay paying taxes. The 401 (K) owner is not liable to pay the tax.
Except for QRDOs, irrespective of the reason for the withdrawal, the amount is taxable if your 401(K) is a traditional loan.
It is an acceptable conclusion that a 401 (K) is a convenient method of building a retirement corpus to fall back on. If you contribute regularly, you can be assured of a fund that will stand by you during one of the financially challenging times of your life.
Q. What should I learn before investing in a 401(K)?
Always try to find out how much your employer will contribute to the 401 (K).
Q. Is there a difference between a 401(K) retirement plan and a traditional pension plan?
Though a 401 (K) allows you to plan for retirement, it is not a traditional pension plan.