Many employees have an option of saving for retirement through an employer sponsored retirement plan. One option is a 401(k) plan. This is known as a salary reduction plan. While your take home is less, you also postpone income tax on those monies.
Contributing to your company's 401(k) has many benefits, including free money. Yes, that's right, free money. The more you contribute the more free money you will get. Here's how:
- You get an immediate tax break each time you are paid as 401(k) contributions come directly out of your paycheck before taxes are withheld, thereby lowering your taxable income.
- If your employer matches your contribution in any way at all, this is free money to you. Most employers give you 50 cents on the dollar up to the first 6 percent you contribute.
- Your contributions grow tax-deferred. This means that you do have to pay taxes on capital gains, dividends and other distributions until you will it out.
How much can you contribute?
In 2011, you can increase your annual contributions gradually up to $16,500. If you are over the age of 50, you can increase that amount by an additional $5,500. Keep in mind that although federal law establishes the guidelines for what is permissible in 401(k) plans, your employer my have some restrictions.
Further, there are other non-discrimination tests a 401(k) plan must pass. For example, one applies to highly compensated employees. If you're classified as a "Highly Compensated" employee then, you may be subject to contribution limits based on your employer's overall 401k participation rates. If your salary is above $110,000 in 2011, then you may need to contact your employer to see if any additional limits apply to you.
In case you are thinking of cashing in your chips before retirement, be mindful that if you pull out money before the age of 59 ½ you may owe taxes on that amount plus a 10 percent penalty, the only exception being IRS rule 72(t). Under this rule, you must take a fixed amount of money out for five years or until you reach 59-1/2, whichever is longer. The annual withdrawal amount is based on your life expectancy.
Portability
At some point you may decide to change employers for any number of reasons. One great feature of a 401(k) plan is that they are portable. This means you can move the money you have accumulated within your plan to your new employer, if their plan accepts transfers. If not, you can always roll that money over into an IRA. If you choose not to transfer it as you are satisfied with the performance of your previous employer's plan, you may be able to leave that money right where it is. That is up to your previous employer. Even once you retire, some employers may allow you to keep your money untouched in their plans until you reach the age of 70 ½. That is the age when the government insists you begin withdrawing money from both 401(k) and traditional IRAs.
While you do have the option of withdrawing your money early, as mentioned above, there are penalties. Ideally, you should keep your money invested in either the 401(k) or IRA and use the money at retirement as it was intended to be used.