If you’re an employee, chances are you already know what a 401k plan is, but few of us actually completely understand what it is.
The principal idea of a 401k plan is to help employees save assets for retirement.
When you open up a 401k account a percentage of your paycheck is automatically deducted on each pay period before it can be taxed and put into a 401k plan, where it will be invested and diversified into stocks, bonds, and mutual funds.
401k plans have proven to be popular with employees for several reasons. Chief among them is the tax deferral where your money grows, untaxed, until you withdraw it in retirement. At that point, you pay taxes on your withdrawals at the regular income tax rate. Imagine what the power of tax-free compounding can do to your retirement income in say, 30 years down the road.
Others include the increased portability of this plan, which means you have the option to transfer your money from one account to another retirement account for better investment opportunity. We have discussed at length some of the options to rollover your 401k account.
And here’s the part that makes 401k irresistible, the free money (from your employer) by way of employer matching contributions. The employers often offer to match some or all of what you invest in your 401k (but are not required to do so).
It could either be a dollar for dollar contribution or $ .50 for $1 or whatever amount that employer might deem fit. For example if your employer matches $ .50 for every dollar you contribute, for every $1,000 you deposit, your employer will match it with an extra $500.
But don’t assume that all employers will match your contribution. If you’re unsure, talk to them and figure out your employer’s retirement plan.
Maximum Contribution Limit
There is a yearly maximum contribution that limits how much you can set aside into your 401k account, which changes every year due to inflation. Each individual employee can defer in 2010 up to $16,500 or 100% of compensation, whichever is less.
In general, you can contribute up to a maximum of 10% contribution of your salary before taxes are calculated. For instance if you are making $50,000 a year and you’re only allowed to contribute 10% of your paycheck, your maximum contribution limit is $5,000 a year, not the $16,500 contribution limit in 2010.
Early Withdrawal Rules
When you withdraw money from your 401k account, you have to pay the taxes on all money that you are withdrawing. Remember you don’t pay taxes on the money that is deposited so you must pay them when it is withdrawn.
In addition if you are under the age 59 ½ you will also have to pay a 10% penalty on your money as part of an early withdrawal fee. After all, a 401k plan should be treated as what it is – a long term retirement savings, so using it early goes against the whole idea.
What If You Leave the Company?
If you leave the company your 401k plan will continue to stay intact unless you roll it over to another tax-deferred retirement account.
There are many possible ways on how to rollover your 401k plan. Your money can either be rolled over into a new 401(k) account by the new employer or roll the money over to an IRA or possibly Roth IRA.
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2010 Contribution Limits
The 401(k) contribution limit for is $16,500 for those under 50 years old. For anyone between the ages of 50 and 59 ½ years old you also have the option of contributing an additional $5,500 as a catch-up contribution.The IRA contribution limit for is $5,000 for those under 50 years old, with a $1,000 catch-up contribution option for those between 50 and 59 ½ years old.