A 401(k) account is the standard retirement plan for millions of Americans. Yet, despite widespread use, 401(k)s remain elusive to many workers.
“They are foreign to people, and the education isn’t there,” says Andrew Rafal, founder and president of the financial firm Bayntree Wealth Advisors in Scottsdale, Arizona. Many workers receive 401(k) plans without any discussion or information about how they work or how to maximize their use.
If you’re feeling confused about how to best contribute to a 401(k) plan — and leverage benefits — keep reading for answers to nine common questions.
[See: How to Max Out Your 401(k) in 2018.]
How can I borrow from my 401(k)? A 401(k) plan may be among your largest assets. While intended for retirement, the law allows participants to borrow up to $50,000 or 50 percent of their vested balance, whichever is less. Each 401(k) plan is structured differently. Some plans may have restrictions on loans, such as only allowing them in cases of financial hardship, while others may allow loans at any time and for any reason, like paying off debt.
“It’s generally quite easy to take out a loan,” says Holly Peterson, founder and president of the financial firm Elite Retirement Strategies in Pocatello, Idaho. There’s no extensive application process and no credit check required. Some plans allow workers to request a loan by filling out an online form or sending a request through the mail. For plans that have hardship requirements, supporting documentation may also be required.
By law, loans must be paid back in no more than five years. If you leave your employment while repaying a loan, the balance must generally be repaid within 60 days or it is considered a distribution that could be subject to taxes and penalties.
What’s the difference between a 401(k) and a Roth 401(k)? The main difference between a traditional 401(k) and a Roth 401(k) is when taxes are paid. Contributions to a traditional 401(k) are deductible, but withdrawals are taxable in retirement. There is no deduction for contributions made to Roth 401(k)s. However, withdrawals from those accounts are tax-free in retirement.
“If you receive a deduction, at some point, the government is going to want its taxes back,” says Justin Fort, certified financial planner, founder and president of the financial firm Fort Wealth Management in Austin, Texas. To make sure they get those taxes, the government imposes a required minimum distribution, or RMD, on traditional 401(k)s once a person reaches age 70 1/2. Using a formula based on the account’s balance, the RMD is subject to income tax. Since withdrawals from Roth 401(k)s are not subject to tax, there is no RMD for these accounts.
What is the max 401(k) contribution? For 2018, workers can contribute up to $18,500 to a 401(k) plan. Those who are age 50 or older are entitled to make catch-up contributions for a total of $24,500 this year. Including employer contributions, a maximum of $55,000 can be contributed.
[See: 9 Ways to Avoid 401(k) Fees and Penalties.]
What is the difference between a 401(k) and a 403(b)? The terms 401(k) and 403(b) refer to different sections of the tax code. The 401(k) section refers to retirement plans offered by the majority of employers. Meanwhile, 403(b) plans are available to nonprofit organizations. There are also 457 plans that are used mainly by municipalities and government employers.
“At the end of the day, they are going to do the same thing,” Rafal says. They have the same contribution limits and operate largely in the same way.
Is there a way to withdraw money early without paying a penalty? The law is designed to encourage workers not to dip into their 401(k) plans until they are 59 1/2 years old. If you take an early withdrawal, it’s subject to a 10 percent penalty in addition to any other required taxes. However, Fort says there are two ways people can take early withdrawals and avoid the penalty.
The first applies to those who leave a job at age 55 or older. If you leave a job at that age, you’re entitled to take withdrawals from your 401(k) without penalty. However, a worker is only able to do that so long as they don’t roll over the money into a different account. Fort says this can be a strategy to fund an early retirement. “People who have multiple old 401(k)s can move all those 401(k)s to their current employer,” he says.
The other option involves Rule 72(t). This refers to an option in the tax code to take out regular, periodic payments from a 401(k) plan early on. These payments can be set up and used by workers of any age. However, once the amount of the periodic payments is set, it cannot be amended. It can be a complex process, and workers may find it difficult to set up 72(t) withdrawals without professional help.
What happens to a 401(k) when you quit your job? Upon leaving a job, an employee has four main options for their 401(k) plan:
— Leave it with the former employer
— Roll it over to a 401(k) plan at a new employer
— Roll it over to an IRA
— Cash it out
While leaving a 401(k) with a former employer is easy, it may make it hard to manage retirement funds in the long run. Keep in mind, rolling the balance over to a 401(k) plan at a new job may take some work but simplify money management overall. Meanwhile, IRAs typically have more investment fund options, but they don’t benefit from the protections of the Employee Retirement Income Security Act that applies to 401(k) plans.
As for cashing out, “That’s not a great idea,” Peterson says. Not only will workers have to pay taxes on the money, but their long-term financial stability may be wiped out if they use their retirement cash for other expenses.
How can you start a business 401(k)? Given the complexity of ERISA and other applicable laws, many small businesses find opening a 401(k) plan for employees to be a daunting task. “An employer needs to have all its ducks in a row,” Rafal says.
Most turn over the process to an administrator, like a financial firm, to handle the plan setup and maintenance. Peterson says the upfront costs for a small business can range from $1,500 to $3,000, but a company gets tax benefits that can offset that cost.
Can you have a 401(k) if you’re self-employed? Yes: One-participant 401(k) plans, also known as solo 401(k)s or individual 401(k)s, are relatively easy to set up through financial firms such as Fidelity, Merrill Edge and Vanguard. Initial fees can be as low as $100 and monthly costs may run for approximately $20.
What questions should I be asking about my 401(k)? The most important questions about 401(k)s are the ones workers should be asking their employers, Peterson says. The following are provisions that can vary significantly by plan. “A lot of these can be a bit confusing,” she adds.
— What are my investment options?
— When can I start contributing?
— Are contributions automatically started?
— What are the fees?
— Is there a match?
— Who manages it?
— Can I take out loans? If so, is there a hardship requirement?
— When do I become vested?
[See: How to Pay Less Taxes on Retirement Account Withdrawals.]
The human resources department should be able to walk you through the answers. If they are unsure, 401(k) administrators typically also have representatives and resources available to explain plan provisions.
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9 401(k) Questions — Answered originally appeared on usnews.com
