401k Retirement Planning Basics

401k retirement

Information You Need To Know

How many financial workshops, put on by your employer for the benefit of you and your fellow 401k participants, have you attended only to completely lose interest after the presenter recites more rules and regulations than you can count? If you are tired of 401k retirement rules and regs you are not alone. Retirement plan rules can get so annoying that some people completely ignore retirement planning altogether. Don’t let that happen to you. Don’t let the rules make retirement investing so complicated that you just check out.

The best retirement plans are those that are simple for you the user to follow. If you understand the rules you will be more likely to take advantage of the investment opportunity that retirement plans offer. Let’s simplify those rules and regs so that you learn to use them to benefit your financial future instead of allowing them to make you crazy.

The Nuts & Bolts Of Rules

401k plan rules, which are non-negotiable, are actually designed and regulated by the Internal Revenue Service (the IRS) and the Department of Labor (the DOL). If you have issues with any of the 401k plan rules, go easy on your employer. Your employer did not create the rules, they are just obligated to enforce them.

We all know that Social Security has become a weak source of retirement money. The majority of Americans will be heavily relying on their 401k’s and other personal investments for retirement. So believe it or not, as an investor you actually want tight regulations because those regulations protect your retirement savings.

401k rules spell out what employers who offer 401k’s must do and what plan participants can and cannot do. If employers do not abide by the 401k rules they could be fined. If participants break the rule, they could be taxed and fined. The 401k plan rules that you as a participant should become familiar with include: plan investment types, contribution limits, rollover, job changing and distribution rules.

401k Investments

Your employer determines the investment platform within your 401k plan. The employer works with a financial advisor to select the investment funds. It is the fiduciary responsibility of the employer to select investments that are well diversified and cover all asset classes. So employers have to be careful when they make the investment selections for the 401k plan. A well diversified 401k plan would included high, medium and low risk investments as well as a money market fund or cash equivalent.

IRS regulations stipulated very clearly that 401k plans can only offer certain types of investments.

These investments include stock, mutual funds, bonds, money market accounts or a cash equivalent. The IRS is confident that those standard investment choices will have moderate but not drastic swings therefore are relatively safe for plan participants. Since 401k plans are so highly regulated investments outside of these standard investment vehicles are not allowed.

401k Contribution Limits

The 401k contribution limits may changed every year to keep pace with inflation. For tax year 2016, the maximum standard 401k contribution limit is $18,000. Next year that may remain the same or again, it could change.

Several years ago Congress added what is called a “catch-up” contribution. This provision allows eligible participants over 50 years of age an additional deferral amount that exceeds the standard contribution amount. The “catch-up” deferral amount for tax year 2016 is $6,000. So if you are 50 or older you can contribute $24,000 for tax year 2016.

Options When Changing Jobs

You have 4 options if you change jobs and have a 401k account. You can leave it, roll it, transfer it or cash it out.

#1 – Leaving It

You can leave your current balance in your old employer’s 401k account. Sometimes people even leave it there until retirement and then take their distributions from that account. It all depends upon your whether or not your old employer’s plan allows this option; some do, some do not.

#2 – Rollover

With the rollover option you actually receive a distribution check. You then have 60 days to reinvest that distribution check into another qualified plan. Another qualified plan can be your new employer’s 401k plan or even an IRA. If you are under age 59 1/2, that check must be reinvested into another qualified plan. If you do not reinvest that check within the 60-day rollover window you will be taxed and also incur the 10% tax penalty. The IRS is very strict about the 60-day rollover period so be careful, there is no grace period beyond the 60 days.

#3 – Direct Transfer

The most seamless, less risky option to move money from one qualified plan to another is called a plan-to-plan or trustee-to-trustee transfer. With this option your money is transferred from one company to the other. The money is never sent to you. The 60-day rollover rule does not apply when you implement this option because you never touch the money. You are also not taxed or penalized, again, because you never touch the money.

#4 – 401k Cash Out

The least desirable option as far as taxation and penalties go is the cash out option. When you cash out you actually receive the distribution money and do not reinvest it into another qualified plan. If you are under age 59 1/2 you will be taxed and charged a 10% penalty on the money you receive. To avoid excessive taxation and penalties your best bet is to choose to either rollover or directly transfer your 401k account when you change jobs.

401k planningMore Rules

The IRS and DOL established strict 401k rules about early withdrawals and distributions to make it difficult for investors to tap into their 401k’s on a whim. Qualified retirement accounts such as 401k’s were established for the intent purpose of helping individuals prepare for retirement. Easy rules would defeat the purpose. 401k accounts were never intended to be used as savings accounts where you make regular withdrawals for day-to-day living expenses…checking and savings accounts are for that.

Withdrawal Rules

The IRS stipulates that withdrawals made from your 401k account before the age of 59 1/2 are considered “early” withdrawals, therefore, taxable and subject to a 10% penalty. A perfect example of an “early” withdrawal is a 401k cash out and sometimes a loan. 401k loans that do not get paid back are considered to be “early” withdrawals.

Hardship Withdrawals

Not all 401k plans allow for hardship withdrawals; if your plan does here are rules that apply. A hardship withdrawal is considered an “early” withdrawal therefore subject to taxation and a 10% penalty if you are under age 59 1/2. Unlike loans, hardship withdrawals do not have to be paid back. You may qualify for a hardship withdrawal if you need the money for: the purchase of a primary residence, medical expenses, to pay for the cost of higher education, funeral expenses or to prevent eviction from your home.

Distribution Rules

Your 401k contributions were always made on a pre-tax basis therefore, never taxed. Distribution money gets included in your taxable income the year in which you take the distribution. You can avoid unnecessary taxes if you delay your distribution until after age 59 1/2. Remember most distributions before age 59 1/2 are considered by the IRS to be “early” withdrawals.

When you retire you can receive your distribution in the form of a lump sum, partial withdrawal, periodic installment payments or roll your money into an IRA. You also have the option of not taking an immediate distribution by leaving your 401k account balance in your employers 401k plan.

Loan Rules

401k accounts are supposed to be long-term investments, for your retirement. But if you are in need of money and have no other resources you can access your 401k account balance by borrowing against your balance. A 401k loan vs a withdrawal is your better option.

The IRS does not require 401k plans to offer loan capabilities but most 401k plans do. You can usually borrow up to 50% of your vested account balance. Loans do not have to be paid back; but there’s the catch. 401k loans are not subject to taxes or penalties, unless they are defaulted on or unpaid. The IRS considers unpaid 401k loans to be “early” withdrawals and you will be taxed and hit with the 10% penalty if you are under age 59 1/2.

Loan repayments are made through payroll deductions. If you happen to change employers with an outstanding 401k loan, you will have to pay that loan back within 60 days. If you cannot pay it back within those 60 days, it is considered a default.

Also worth noting, 401k loans cannot be rolled into IRA’s.

401k Rules Complete

401k plans offer so many benefits that it is such a waste of money and earning power to avoid contributing to one. So now that you have learned a bit more about 401k plan rules and regulations and the reasons behind them you should be able to approach your retirement planning with more confidence. Always remember that no one cares about your retirement more than you do.