The Top 9 Things to Know About Your 401(k)

By Kevin Mercadante

| Photographs By maroke

The 401(k) is a common retirement plan. In fact, it’s the most common employer-sponsored retirement plan. But there’s much about 401(k) plans that participants don’t know. Here are the top nine things to know about your 401(k).

1. The maximum contribution you can make has increased for 2018

The maximum employee contribution to a 401(k) has held steady at $18,000 for the past couple of years. But for 2018, it has increased to $18,500. That’s not a big increase, but it’s headed in the right direction.

Once more, if you are age 50 or older, you can make a “catch-up contribution” of an extra $6,000. That amount hasn’t changed, but it does mean that those 50 and older can contribute up to $24,500 to their 401(k) plans. When you add an employer matching contribution of some amount, it really begins to add up.

2. You can contribute up to 100% of your income

Some employers may limit employee contributions to a certain percentage of their income. And even where they don’t, employees may assume that some limit exists.

But in point of fact, the IRS actually allows you to contribute up to 100 percent of your income to a 401(k) plan. The catch is that the contribution cannot exceed the maximum employee contribution amount, of $18,500, or $24,500 if you are 50 or older.

If you earn $50,000, you could — in theory at least — contribute 100 percent of the first $18,500 you earn.

3. Some 401(k) plans have a Roth provision

An increasing number of 401(k) plans are adding a Roth 401(k) component. It works very much like a Roth IRA, but it has certain advantages.

One is that an employer can offer matching contributions on the employee’s contributions. The only catch is that the employer contribution portion has to be placed into a regular 401(k) account. That’s because the employer portion will not be tax-free in retirement, the way the employee contributions will be.

An even bigger advantage is that contributions to a Roth 401(k) are much higher than for Roth IRAs. On a Roth IRA, the maximum contribution is $5,500, or $6,500 if you’re 50 or older.

But Roth 401(k) employee contributions can be up to the maximum 401(k) contribution. That means you can contribute up to $18,500 to your Roth 401(k), or $24,500 if you are 50 or older. You can also divide the contribution between the Roth and regular 401(k) portions.

4. You can contribute to other retirement plans even if you have a 401(k)

Even if you participate in a 401(k) plan, you can still contribute to other retirement plans. Under IRS regulations, contributions to all retirement plans have a maximum of $55,000 for 2018 (up from $54,000 in 2017).

In theory at least, if you contribute the maximum of $18,500 to your 401(k) plan, you can still contribute as much as $36,500 to other plans.

It’s also important to understand that there are limits to how to make that happen. In order to contribute to other plans, you first have to be participating in them.

The two most common plans are the traditional and Roth IRA. The IRS has special stipulations regarding income if you also participate in a 401(k) plan:

Apart from traditional and Roth IRAs, you can also make contributions to self-employed retirement plans if you have your own business.

These plans include:

  • SIMPLE IRA — allows you to contribute up to $12,500 of self-employed income, plus a $3,000 catch-up contribution if you are 50 or older.
  • SEP IRA — Up to $55,000 of self-employment income, less contributions made to your employer 401(k) plan.
  • Solo 401(k) — Up to $55,000 of self-employment income, less contributions made to your employer 401(k) plan.

5. Your employer is NOT required to offer a loan provision

It’s often believed that loan provisions are an inherent part of 401(k) plans. But while the IRS permits 401(k) loans, it’s up to the employers whether or not they want to offer them. Some don’t. And when they don’t, they’re not violating any sort of law. It is their choice to offer them or not, and not all do.

6. There are at least two vesting methods

Any contributions to a 401(k) plan made by the employee are immediately vested. That means the employee has 100 percent ownership of the funds. That includes investment earnings on those funds.

But the situation is different when it comes to employer matching contributions. Those are subject to vesting rules. Should employment be terminated for any reason before vesting occurs, the matching contributions will revert back to the employer.

But there are actually two types of vesting with 401(k) plans, “cliff testing” and “graded vesting.”

Cliff vesting is where vesting takes place all at once. For example, employer matching contributions may not be vested for the first two years that an employee participates in a plan. But at the beginning of the third year, the contributions are 100 percent vested.

Graded vesting is where vesting takes place gradually. There may be no vesting in the first year of participation. In the second year, the employee is 20 percent vested. In year number three, she’s 40 percent vested. And in year number four, she’s 80 percent vested. After five years, the employee is 100 percent vested in the employer contributions.

The moral of the story: Always find out which vesting method your employer uses.

Never assume it’s the same one your last employer used.

7. Hardship withdrawals from a 401(k) are not the same as those for an IRA

IRS regulations permit early withdrawal of funds from retirement plans without the requirement to pay the 10 percent early withdrawal penalty. Participants sometimes confuse hardships between 401(k) plans and IRAs.

For example, IRA plans permit hardship withdrawals for education and first-time homebuyers; 401(k) plans don’t.

Never assume that the hardship withdrawals permitted from an IRA also apply to a 401(k).

8. There’s a way to take early 401(k) withdrawals without penalty before 59½

The general rule with 401(k) plans, and all retirement plans for that matter, is that there is a 10 percent early withdrawal penalty if you withdraw funds before turning age 59½. But that’s only the general rule — there’s an exception — apart from hardship withdrawals.

It’s referred to as substantially equal periodic payments. It enables you to avoid the 10 percent early withdrawal penalty if you are separated from your employer before turning 59½.

By setting up the distributions to create a series of substantially equal periodic payments, you can avoid the penalty. The IRS provides three different calculations to determine those distributions. Perhaps most common is where distributions are made based on your life expectancy.

It’s a bit of a complicated process, but it offers an opportunity to avoid the penalty if you must take early withdrawals.

9. You MUST begin taking withdrawals from your 401(k) by age 70½

Funds cannot continue to accumulate in a 401(k) plan forever. IRS regulations call for required minimum distributions (RMDs) on all retirement plans beginning at age 70½ (the lone exception is the Roth IRA, but not the Roth 401(k)).

Distributions must at least be based on your remaining life expectancy. That means that as each year passes, and your life expectancy declines, the amount of the distribution will be a little bit higher. This provision forces money out of tax-sheltered retirement plans, and into taxable income.

There is one exception for 401(k)s, and that’s if you are still employed after age 70½. You can’t continue to make 401(k) contributions at that age, but you won’t be subject to RMDs, either.

Summary

There’s a lot to know about retirement accounts. Your 401(k) alone is complicated enough. So, these are nine important facts to get you started.


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