Here’s What You Should Know About Your 401(k)

How to get the most out of your 401(k)

With the start of a new year, many are asking questions about their 401(k). This is especially important for those intending to retire in the next five years. And while these plans provide a wonderful benefit, they are still regulated by the government and are packed with rules. Here are some of the basics you need to understand about your 401(k) plans and retirement accounts.

How much can I contribute in 2017? 

The contribution limits for 2017 are the same as they were in 2016. If you are under 50 years of age, you can contribute up to $18,000. If you are 50 years or older, you can make an additional catch-up contribution of as much as $6,000, for a total of up to $24,000.

Keep in mind that the total amount contributed by you and your employercan be much higher with a combined limit of $54,000 (for the employee contribution and the employer match).

What about a “Solo” 401(k)? 

Those who are self-employed and do not have any employees (such as Realtors™, self-employed contractors, solo-professionals, etc.) may contribute the same as above, and will also have the same combined limit of $54,000.

Keep in mind, however, that the limits on elective deferrals are by the person and not by the plan. For example, a business owner (or self-employed individual) who is also employed by a second company and participates in its 401(k) plan is not allowed to defer additional contributions beyond these limits.

What about “highly compensated employees”? 

For 2017, employees earning more than $120,000 shall be deemed to be “highly compensated.” The IRS does not want a company’s 401(k) plan to favor those with the highest earnings. Therefore, they require employers to perform an annual “census” to ensure that their most highly compensated employees are not contributing a far greater percentage of their salaries to their 401(k) plan than are other employees. If those earning less than $120,000 per year are contributing to their plan at a lower rate than those earning more, then the contribution limits the higher paid employees may be lowered.

What is the difference between a 401(k) and a Roth 401(k)?

The contribution rules for a Roth 401(k) and a Solo Roth 401(k) are exactly the same as a traditional 401(k) and Solo 401(k). The difference has to do with when the participating employee (or self-employed professional) pays taxes.

Think of it this way: the IRS expects to be paid on the amount you earn. With regard to your qualified retirement plan, such as a 401(k) or Roth 401(k), you will pay taxes on either the seed or the harvest.

Taxing the Harvest. With the traditional 401(k) the employee does not pay taxes until money has had a chance to grow in a tax deferred manner and is then withdrawn from the account. The benefit to this is that it allows for more of your earnings to be invested for your retirement.

Taxing the Seed. In a Roth 401(k), just as in a Roth IRA, contributions to the plan are made with after tax dollars. Because your taxes have already been paid, you will not owe taxes when you begin to withdraw from your account. Also, since taxes have already been paid, the withdrawals from both a Roth 401(k) and Roth IRA are tax free.

Do I have to start taking a required minimum distributions (RMD) for a traditional 401(k)? What about a Roth 401(k)?

Generally speaking , in the yeara when you reach the age of 70 1/2 you must begin taking required minimum distributions (RMD) from both your Traditional and your Roth 401(k). The RMD is based on the balance in your account at the end of the previous year and the life expectancy for your age as determined by the IRS. If you have several 401(k)s and have not rolled them over to a single account (see below), the RMD is calculated separately for each account.

If you have reached the required age and are still working for the employer sponsoring the 401(k) plan, you may not be required to take an RMD until you retire.

You can avoid having to take future RMDs from a Roth 401(k) or Solo Roth 401(k) by rolling the money over to a Roth IRA, since Roth IRAs are not subject to required minimum distributions.

Can I borrow from my 401(k)?

Most plans will allow you to borrow from your 401(k). Generally speaking, you can borrow up to one-half the vested balance in your account or $50,000, whichever is less. This is true for Solo 401(k)s as well, making this ideally suited for Realtors™ and business owners.

Before doing so, however, you should give the idea considerable thought. Depending on your plan, employers may be able to withhold their match while the loan is outstanding. And if you leave the company – for any reason – the loan may be called in. If you are not able to repay the loan, you’ll owe income taxes on the entire amount plus a 10% early withdrawal penalty if your are under age 55.

When can I start withdrawing from my 401(k)?

Generally speaking, you have to wait until age 59 1/2 before withdrawing from your account without experiencing a 10% early-withdrawal penalty. But, if you are age 55 or older and you permanently leave your job, you can begin drawing money from your 401(k) without owing the penalty. This exception is called, “separation of service.” Be advised; you will still owe income taxes when withdrawing from your traditional 401(k).

What are “hardship” withdrawals?

Some companies may allow you to permanently withdraw money from your 401(k) when you experience an “immediate and heavy financial need.” Before doing so, you should thoroughly review the matter, otherwise you could owe income taxes plus a 10% withdrawal penalty if you are under the age of 59 1/2. Though your plan may differ, most companies allow withdrawals for the following reasons:

  • To pay medical expenses
  • To cover a down payment or to avoid eviction or foreclosure on your primary residence
  • To pay college tuition
  • To cover funeral expense for a family member.

Should I rollover my 401(k) from my former employer to my new employer’s program?

Unless you want to borrow from the account you probably do not have a good reason to roll your 401(k) into another one. Instead, you should roll the funds into your own IRA.

Rolling your 401(k) into an IRA gives you significantly more control over your money. First, you will be able to invest in thousands of mutual funds, ETFs, etc. rather than the few investment options available in most 401(k)s. Your investment advisor will be able to guide you so that your entire portfolio, even your new 401(k), is properly aligned with you financial goals. If not, then find a new advisor.

When rolling over your 401(k), be sure use a direct “trustee-to-trustee” transfer. Otherwise you will be hit with an automatic 20% withholding for federal income tax.

 

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