What is 401k ? – A Smart Guide to Help You Make the Most of the Current Market
401(k) is a saving plan that allows you invest a part of your paycheck today to create income for your retirement. By knowing what is 401k, you can exercise complete control over your investments, defer paying taxes until withdrawal, and stay guarded against wide market swings.
Tax Benefits for Using 401(k)
A 401(k) not only is one the most important retirement plans available but also allows you to lower your tax bills. Investing in a traditional 401(k) will lower your taxable income and you won’t be liable to pay any taxes until you retire. If you opt for a Roth 401(k) you also get a different type of tax break wherein your contributions are taxable, but it makes your money totally tax-free on retirement. When an employer makes a matching contribution, even if it is a small match, the contributions become tax deductible. You can also consult a financial advisor to figure out a tax-free retirement plan.
Types of 401k
Traditional: When you opt for a traditional 401(k) plan, you contribute from your paychecks and lower your taxable income. The contributions are “before tax”. If you leave your employer at the age of 55, you cannot access your funds until you turn 59½ without incurring a penalty from the IRS. This penalty disappears once a person reaches the age of 59 ½.
Roth: Your contributions are “after tax” meaning they do not lower your tax rate. However this allows for a tax-free withdrawal when you retire. It offers better flexibility in terms of access as long as you have been contributing for at least 5 years.
The maximum contribution limit for 401(k) accounts in 2018 is rising to $18,500 for elective contributions, up from $18,000 in 2017. Elective contributions are money you choose to have withheld from your paycheck and invested for retirement.
For older workers 50 and up, additional catch-up contributions are permitted. Catch up contributions are additional elective contributions older workers can make on top of the $18,500 every eligible worker can invest. In 2018, older workers are allowed to make catch-up contributions of $6,000. People 50 and over will be allowed to contribute a maximum of $24,500 in elective contributions in 2018, compared with $24,000 in 2017. Employer match or profit share can increase the total annual 401(k) contributions to $55,000. For persons 50 and over, the total contributions increase to $61,000. The personal deferral in either case can be Roth or Traditional or any combination thereof. This can really help for tax planning.
|Defined Contribution Plan Limits||2020||2019||Change|
|Elective contributions for all eligible workers ||$19,500||$19,000||+$500|
|Catch-up contributions for workers 50 and over||$6,500||$6,000||+$500|
|Defined contribution maximum from all sources for workers under 50||$57,000||$56,000||+$1000|
|Defined contribution maximum from all sources for workers 50 and over ||$63,500||$62,000||+$1500|
|Employee compensation limit for calculating contributions||$285,000||$280,000||+$5,000|
|Key employees' compensation threshold for nondiscrimination test testing||$185,000||$180,000||+5,000|
|Highly compensated employees' threshold for nondiscrimination testing*||$130,000||$125,000||+5,000|
According to the restrictions imposed by the IRA, withdrawals before reaching the age of 59½ will be subjected to an excise tax of 10% of the total withdrawal – over the above the regular income tax. You may opt for a hardship withdrawal if permitted by the employer. It is generally granted in case of a foreclosure, an emergency medical expense, mortgage payment, payment of educational fees, or for paying funeral expenses.
Required Minimum Distributions (RMD)
Account owners need to take distributions when they turn 70 ½ or by the 1st of April, whichever is later. The calculation of the required distribution is based on the life expectancy. Starting from the first year, you should be receiving the distribution by the 31st of December for every consecutive year. If you miss out on receiving the minimum distribution, you will invite a penalty. Your financial advisor or plan administrator will help you determine the right amount for each year. You can also opt for a lump-sum distribution if you need a big chunk of cash or you can go with a monthly or quarterly distribution.
Learn How to Avoid RMDs Within your 401(K)s
Force-out Provision for Former Employees
Terminated employees who have a low balance can close their 401(k) account. The balance limit for a force-out plan is $1,000. You can also roll over the balance amount to an IRA or go with the option of cash out.
If you are laid off or downsized or just leave your job you can roll over your 401(k) to another qualified account. A qualified account can be an IRA or a new self directed 401 k for those who qualify. These rollovers will not attract tax or penalties. If you plan to rollover your funds after a distribution, the entire procedure should be accomplished within a period of 60 days. If you exceed the stipulated time frame, your rollover will be become a taxable distribution.
The end of the calendar year is the deadline for personal deferrals. For an LLC, a partnership, or a sole proprietorship, the contribution deadline is set for the 15th of April unless an extension is filed. In this case, the personal tax-filing deadline (15th April) gets extended to 15th September.
All 401 k plans will have some type of fees. However they are kept to a minimum vs. private investing. Most company 401 k plans will be administered by a financial institution and will offer an array of investment choices. These choices will generally be a mix of stocks, bonds or mutual funds.
Self Directed 401 k’s
More and more individuals and small business owners are looking into self directed 401(k) plans. These plans are cost effective, easy to manage and are a great employee hiring and retention vehicle. They allow for a much broader range of investments such as real estate, precious metals, tax liens, private placements etc. Each plan participant can invest in what interests him or her!
At Self Directed Retirement Plans LLC, we have been establishing self directed 401(k) plans for twelve years. If you would like to learn more, please log onto www.sdretirementplans.com, go to 401(k) basics and FAQ’s. This will help you to better understand about the self directed 401(k) world.