To become a better investor you need to know the current 401k rules. You should start by making yourself aware of the 401k rules most often referred to by 401k participants: 401k contribution limits, 401k distribution rules and 401k early withdrawal rules.
All these 401k rules were established by the Internal Revenue Service (IRS) and the Department of Labor (DOL), not your employer or your 401k plan sponsor. So if you ever have issues with the rules, go easy on your employer. Your employer may be able to explain the rule to you; but they did not invent it.
401k rules are tightly regulated by the DOL and IRS and are non-negotiable. If employers or 401k plan sponsors do not abide by the preset 401k rules, they could be fined. In some cases, the fines can be rather steep.
Let’s review the 401k rules that most often concern 401k participants.
401k Rule Secrets Revealed:
401k contribution limits:
- 401k contribution limits may change every year to keep up with inflation.
- For the 2010 tax year, the 401k contribution limits are $16,500.
- The catch up contribution limit for 2010 is $5,500.
- Congress added what’s call a catch up provision to allow eligible participants over 50 years of age an additional deferral amount that exceeds their standard 401k plan contribution.
- So if you are 50 or over, you can contribute $22,000 in 2010.
401k distribution rules:
- 401k distributions are included in your taxable income the year of the distribution.
- The money in your 401k has never been taxed, and the IRS wants their tax money.
- Your 401k contributions were always made on a pre-tax basis.
- You can receive your 401k distribution in the form of:
- Annuity payments
- Periodic installment payments or
- A lump sum
- Talk with your financial adviser on which distribution method best fits your financial situation.
401k early withdrawal rules:
- The IRS stipulates that if you make a withdrawal from your 401k account before age 59 1/2, that withdrawal is considered a 401k early withdrawal.
- 401k early withdrawals are taxable in the year of the withdrawal.
- You may also incur a 10% tax penalty on an early withdrawal.
- An early withdrawal is different from a 401k loan.
401k loan rules:
- Loans have to be paid back.
- If you do not repay the loan, the IRS considers it an early withdrawal.
- For a loan that’s defaulted on, you will be taxed.
- If you are under age 59 1/2 you will also pay a 10% penalty on the outstanding loan balance.
- Loans have a 5 year payback schedule, in some cases that can be extended.
- Loan repayments are made through payroll deductions.
- If you change employers and still have an outstanding 401k loan with that old employer, the loan must be paid back within 60 days. And if you cannot pay it back, it’s considered a default. You will be taxed and incur a 10% tax penalty.
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. The IRS and DOL established 401k’s to help folks prepare for retirement.
401k accounts are not intended to be used as a savings account where you make regular withdrawals. Open a savings account for regular withdrawals; open a 401k account to prepare for your future retirement needs.