HOW DOES A 401(K) PLAN WORK?
A 401(k) plan is a retirement plan that must be sponsored by a company or employer. Your employer takes a portion of your paycheck before taxes and invests it into an account where it will earn interest. You won't be taxed on this money until you withdraw it.
CONTRIBUTIONS
In 2008, the maximum amount that you could contribute to your 401(k) in one calendar year was $15,500 (pre-tax) if you were under 50 years of age and $20,500 (pre-tax) if you were between 50 and 65 years of age. Those 50 years old and older are allowed an extra $5000 per year as "catch-up contributions" in preparation for their impending retirement.
As an incentive, some employers will match a certain amount of their employees' 401(k) contributions. For example, if your company offers a 25% match and you contribute $10,000 to your 401(k), your employer will contribute an extra $2500. Contributions by your employer are subject to what's known as "vesting."
Vesting is a feature that companies use to reduce employee turnover. It refers to the amount of time you need to work for your company before you keep the full amount of their contribution to your 401(k) upon termination of employment for whatever reason. Your personal contributions to your 401(k) are automatically 100 percent vested. The vesting of your company's contributions accrues over time.
The Employee Retirement Income Security Act (ERISA) has set two different vesting schedules to be used as a minimum guideline.
ERISA 401(k) Vesting Schedule 1
Less than 3 years of work = 0 % of accrued benefits vested
More than 3 to Less than 4 = 20 %
More than 4 to Less than 5 = 40 %
More than 5 to Less than 6 = 50 %
More than 6 to Less than 7 = 80 %
At Least 7 = 100 %
ERISA 401(k) Vesting Schedule 2
Less than 3 Years of Work = 0 % of accrued benefits vested
Minimum of 5 Years of Work = 100 %
To find out which schedule your company uses, read your 401(k) plan summary or contact the human resources department.
WITHDRAWALS
Because your 401(k) is a retirement plan, you can only access this money under certain circumstances once it is invested:
(A) You officially retire at age 55 or older. You will pay tax on this money, but you will not have to pay any early withdrawal penalties.
(B) You apply for and receive a 401(k) loan. You must pay this money back to your 401(k) within a specified period of time, with interest, or you will be charged the taxes and fees that go along with early withdrawal. (For more information on this option, visit http://www.helium.com/items/1298145-borrowing-from-a -401k-plan
(C) You apply for and are granted a hardship distribution. Hardship distributions are subject to income tax and a 10 percent early withdrawal penalty. You do not have to pay them back, but you will be prohibited from contributing to your 401(k) for at least 6 months following the distribution.
(D) You leave your current employer and do not wish to leave your money in their care or you have not accumulated the minimum $5000 required to leave your money in their 401(k) plan.
WHAT HAPPENS WHEN YOU LEAVE YOUR CURRENT EMPLOYER?
When you leave your current employer, you have three options for your 401(k) if you decide not to leave it in their care:
(1) You rollover your 401(k) into your next company's 401(k) plan. You still have no access to the money, but you don't pay taxes or fees.
(2) You rollover your 401K into an IRA (individual retirement account). IRAs aren't tied to a specific company. You don't get charged taxes or fees on the money for rolling over, although some IRA plans charge maintenance fees. If you withdraw the money from your IRA before retirement, you will be charged taxes and an early withdrawal penalty. You only have 60 days to set up your account and rollover your 401(k) money.
(3) You cash out your 401(k). In this situation, you pay 20 percent federal tax on the money, state tax, and a 10 percent early withdrawal penalty. For example, if you've contributed $10,000 to your 401(k), you automatically lose $2000 to federal taxes and approximately $700 to state tax. You will also lose $1000 as an early withdrawal penalty. In other words, of the $10,000 you contributed to your 401(k), you will receive around $6300.