A 401(k) is an employer sponsored retirement plan. It allows employees to have pre-tax dollars deducted from their paychecks for investment. Employers manage the money but employees will select from a variety of investment options. Taxes on a 401(k) are deferred until the money is withdrawn. Employees will decide how much to contribute but the IRS places limits on contributions which may vary yearly. Employers may decide to match contributions, but there is no uniform formula. An employer may contribute nothing, $0.50 for every $1.00 up to a set maximum of 3% to 6% of salary or match dollar for dollar. In concrete terms: if someone earns $50,000 per year, contributes 6% to their 401(k) ($3,000), their company matches $0.50 to the $1.00 up to 3%, the employer “donates” $1,500, making the total contribution in that year $4,500!
Regardless of the level of the employer contribution, a matching contribution is free money for retirement. If your employer offers a 401(k) plan, sign up if eligible. If you change employer, the account will roll over to the new employer. A matching contribution helps the account balance grow more quickly. Most employers will give employees the opportunity to discuss their individual plans with the plan administrator. Other than deciding on how much to contribute, consider your time horizon, look at the performance of the available investment vehicles, understand any fee structure and know your appetite for risk.
Keep in mind a 401(k) is not a saving accounts. As a general rule, taking money out of a 401(k) early should be the last resort. However, for some people, the money becomes a necessity well before retirement. When money is withdrawn prior to age 59 1/2, the amount may be subject to ordinary income tax plus a 10% penalty in some cases. Not all employers allow 401(k) withdrawals. One withdrawal option is a loan against the account balance. Repayment is at an interest rate lower than a conventional loan. Employees have 5 years to repay but if the employee is no longer employed with the company, the loan generally becomes due within 60 days.
The other option is a hardship withdrawal which does not have to be repaid. The hardship must fall within predetermined IRS parameters. The IRS allows a 401(k) distribution to be “made on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need”. The criteria are: (1) prevent eviction/foreclosure of primary residence; (2) purchase of primary residence; (3) certain repairs to primary residence (4) funeral expenses; (5) medical expenses not covered by insurance; and (6) college tuition for yourself, spouse or dependent. Some plan administrators will ask employees for documentation to substantiate the hardship. It’s important to note that taking money out of a 401(k) incurs an opportunity cost. Reducing the balance affects the level of compounding, putting the account off track.