401k Plan Explained

There are many people that have questions about 401k plans. Today, I will take the time to provide you with some information to understand what a 401k plan is. A 401k plan got its name from Internal Revenue Code of 1978. It was administered by the EBSA or Employee Benefits Security Administration of Department of Labor.

A 401k plan has lots of advantages. First and foremost, employees can contribute pre tax money to their plan. This allows employees whose employers that offer the plan to reduce the taxes that they have to pay on their paychecks. The company contribution and any growth in the fund are tax free until withdrawn. The compounding of the fund during a 20 to 30 year period is quite amazing.

Another advantage is that employees can control the direction of their future contributions. And when the company matches your contribution its like getting free money and a immediate return on your investment.

The money in your plan can be moved from one company to another. Unlike other plans which are not transferable. A 401K plan is protected by pension laws since it is a personal investment plan.

Here are two basic concepts and terms that you need to understand about 402k plan:

When you contribute to a 401K plan, a percentage of your salary is deducted from each paycheck. These deductions are deposited into a special account.  Once deposited, you are then able to invest that money in a number of mutual funds based on what you plan offers.

You can take your money out, but it there are penalties that apply. You can borrow money from your 401k by taking out a loan, then paying it back plus interest as well.  I hope this explains some of the benefits of a 401k plan.

Employer’s 401K Rules

Many of your desires to withdraw money from your 401K plan will be governed by the rules and guideline set up by your employer.  Most companies that offer a 401k plan with have an employee handbook that sets forth what you can do and can’t do with your 401k plan.  It will explain how your employer will match if or any of your contributions.  It will state how much you can contribute to the plan, the minimum and maximum amount that you can contribute and who administers the plan.

But more importantly the plan will set forth the guide lines for early withdrawal and whether you can get loan through your company plan.  So it is very important that you read those terms to see what you can do and can’t do.

401k loan

If you been reading our blog, it is pretty clear that you will get taxed at your marginal rate plus the 10% penalty should you decide to withdraw money from your 401k Plan.  Your marginal rate will also be slightly higher than what you normally pay because the amount that you withdraw from your plan with be taxable income and added to your total gross income the year.

Plus, there are no guarantees that your employer will allow you to take the money out the plan but for the stake of discussion we will assume that they will allow you to.

Another option at your disposal that is rarely discussed is that you can take a loan from your 401k plan.  The loan will be at around 7% interest and the interest paid on the loan goes back into your account so it cost you nothing to get the loan.  As long as you plan to stay at your current employer through the duration of loan payback period it is a great option.  However if you leave they you have to pay the entire loan in full or it is treated as an early withdrawal for which you must pay the 10% penalty on as well as the marginal tax on it.

So it might be worth your time to talk to your Human Resource department about your loan options.

Using Money to Buy a Home

The government wants to encourage home ownership and although they want to deter people from withdrawing money out of the retirement plan, they do allow first time home buyers to withdraw up to $10,000.00 out of their IRA plan without imposing a 10% penalty on that money.

If you are married, that means that you and your spouse can take out a combined $20,000.00 without a penalty but that money must be used to purchase your first home together.  But each must withdraw the $10,000.00 from their individual IRA plan and the money must be use and put toward the purchase of their first home.

You are buying your first home, if at the time of purchase, you have not own a home or have any ownership in any home, within the last two years.  If you have owned a home within the last two years then you cannot take the money out without having to pay a ten percent (10%) penalty.

You can also take out more than $10,000.  You just have to pay the 10% penalty on any amount above the initial $10,000.00.  So if you single and looking to buy your first home and decide to withdraw $50,000 from your IRA plan, then you will have to pay the 10% penalty on $40,000.00.  Hope that make sense.

IRS Levy Exception

If you owe money to the IRS and they levy on your 401k plan pursuant to Section 6331 of the IRS code then you do not have to pay the 10% early distribution penalty.  You still have to pay the tax on the amount levy as if it was earned income but you don’t have to pay the penalty.  Technically, this is an exception to the early 401K withdrawal penalty rule.

I guess the public policy exception was created since the money was going to the government and the original purpose behind the 10% penalty rule was to discourage people from withdrawing money early out of their retirement plan.

But the government found a more compelling interest in getting their tax money to use the money to run the country was far more important than discouraging citizens from using their retirement fund money.