In the United States, a 401(k) retirement savings plan allows a worker to save for retirement and have the savings invested while deferring current income taxes on the saved money and earnings until withdrawal. This type of plan is also known as a “traditional” 401(k).
Tax on 401(k)
Depending on whether the plan allows, employees can make contributions to the 401(k) on a pre-tax or post tax basis. With either pre-tax or after-tax contributions, earnings from investments in a 401(k) account (in the form of interest, dividends, or capital gains) are tax-deferred. The resulting compounding interest with delayed taxation is a major benefit of the 401(k) plan when held over long periods of time. Starting in the 2006 tax year, employees can also elect to designate contributions as a Roth 401(k) deduction. Similar to the provisions of a Roth IRA these contributions are made on an after-tax basis and all earnings on these funds not only are tax-deferred but could be tax-free upon a qualified distribution. However, to do so, the plan sponsor must amend the plan to make those options available.
For pre-tax contributions, the employee does not pay federal income tax on the amount of current income that he or she defers to a 401(k) account. For example, a worker who earns $50,000 in a particular year and defers $3,000 into a 401(k) account that year only recognizes $47,000 in income on that year’s tax return. Currently this would represent a near term $750 savings in taxes for a single worker, assuming the worker remained in the 25% marginal tax bracket and there were no other adjustments (e.g., deductions). The employee ultimately pays taxes on the money as he or she withdraws the funds, generally during retirement. The character of any gains (including tax-favored capital gains) are transformed into “ordinary income” at the time the money is withdrawn.
If the employee made after-tax contributions to the non-Roth 401k account, these amounts are commingled with the pre-tax funds and simply add to the non-Roth 401(k) basis. When distributions are made the taxable portion of the distribution will be calculated as the ratio of the non-Roth contributions to the total 401(k) basis. The remainder of the distribution is tax-free and not included in gross income for the year.
For accumulated after-tax contributions and earnings in a designated Roth account (Roth 401(k)), “qualified distributions” can be made tax-free. To qualify, distributions must be made more than 5 years after the first designated Roth contributions and not before the year in which the account owner turns age 59½, unless an exception applies as detailed in IRS code section 72(t). In the case of designated Roth contributions, the contributions being made on an after-tax basis means that the taxable income in the year of contribution is not decreased as it is with pre-tax contributions. Roth contributions are irrevocable and cannot be converted to pre-tax contributions at a later date. Administratively, Roth contributions must be made to a separate account, and records must be kept that distinguish the amount of contribution and the corresponding earnings that are to receive Roth treatment.
Unlike the Roth IRA, there is no upper income limit capping eligibility for Roth 401(k) contributions. Individuals who find themselves disqualified from a Roth IRA may contribute to their Roth 401(k). Individuals who qualify for both can contribute the maximum statutory amounts into both plans (including both catch-up contributions if applicable).
Withdrawal of funds from 401(k)
Any withdrawal that is permitted before the age of 59½ is subject to an excise tax equal to ten percent of the amount distributed (on top of the ordinary income tax that has to be paid), including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year).
In any event any amounts are subject to normal taxation as ordinary income. Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan would have to resign from their employer. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59½ years of age. Money that is withdrawn prior to the age of 59½ typically incurs a 10% penalty tax unless a further exception applies
This penalty is on top of the “ordinary income” tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: the employee’s death, the employee’s total and permanent disability, separation from service in or after the year the employee reached age 55, substantially equal periodic payments under section 72(t), a qualified domestic relations order, and for deductible medical expenses (exceeding the 7.5% floor). This does not apply to the similar 457 plan.
401(k) plans charge fees for administrative services, investment management services, and sometime outside consulting services. They can be charged to the employer, the plan participants or to the plan itself and the fees can be allocated on a per participant basis, per plan, or as a percentage of the plan’s assets. For 2011, the average total administrative and management fees on a 401(k) plan was 0.78 percent or approximately $250 per participant.
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