- 401k plans provide tax advantages for retirement savings.investment image by Kit Wai Chan from Fotolia.com
The Internal Revenue Service allows companies to offer their employees tax-advantaged retirement plans, called 401ks, as part of their compensation package. These plans allow both the company and the individual to make contributions to the account. The money in the account must be invested in one of the options provided by the employer. - Contributions to a 401k plan are made with pretax dollars, meaning that the money is not counted as taxable income. For example, if your salary is $61,000 but you contribute $8,000 to your 401k plan, your W-2 form will only show $53,000 in taxable income. Once the money is in the 401k account, the earnings are not taxed as long as the money remains in the account. This helps the account compound the returns at a higher rate. However, when you take withdrawals from the 401k account, you will have to include that amount as taxable income.
- There is an annual limit on how much you can contribute to a 401k plan. The limit can change on an annual basis, factoring in inflation. For 2010, the annual contribution limit is $16,500. If you are 50 years of age or older, the IRS permits you to contribute an additional $5,500, for a total contribution limit of $22,000. However, your total contribution cannot exceed your earned income. For example, if you only have $15,000 in earned income for the year, your contribution limit is that amount.
- Qualified withdrawals can be taken from 401k plans when you reach age 59-1/2, regardless of your working status. If you leave your company for any reason after you reach age 55, you can also take qualified withdrawals. Early withdrawals are restricted to financial hardships, which occur only when you have significant expenses, such as mortgage payments to avoid eviction or funeral expenses that you cannot pay with any other funds. Most hardship withdrawals also incur a 10 percent early withdrawal penalty on top of any income taxes you owe on the withdrawal. Starting at age 70-1/2, you must start taking required minimum distributions from your 401k plan. The size of the required distributions depends on the value of your account and the expected distribution period of the account as determined by the IRS life expectancy tables.
- Unlike IRAs, 401k plans permit you to take loans from your account for the lesser of $50,000 or 50 percent of your plan value. These loans must be repaid with interest over no more than five years. If you take out a loan to pay for a home, the repayment period can be extended. However, if you fail to repay the loan, the amount will be considered a distribution, and you will be required to pay taxes and penalties.
Tax Treatment
Contribution Limits
Withdrawals
Loans
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