In Graphics: What Is a 401(k) Plan?

WHAT IS A 401(k) PLAN? 401(k) plans are part of a family of retirement plans known as 'defined contribution plans'. They are the most widely used retirement saving vehicles in the U.S. Brief History of 401(k) Plans 1978 1984 1998 2003 2006 Congress amends the IRS code adding 401(k) where employees are 17,303 comapnies offer Congress passes legislation that allows all employees to contribute to their 401(k) plans, unless they elect not to. 438,000 companies offer 401(k) plans., 401(k) plans There are 70 million participants with more than $3 trillion in not taxed on income they choose to defer. assests in their 401(k) plans. 401(k) by the Numbers Based on the average nest egg size of a person in their 30s. 401(k)'s and Job Tenure Average 401(k) Asset Allocation $62,207 $65000 60 56.8% $42,861 $50000 50 $35000 $23,024 40 $20000 $11,502 30 20 $5000 9.3% 7.4% 6.9% 3.0% 4.9% 8.9% 10 1.7% 1.0% Balanced "Funds Bond Funds 0-2 yrs 2-5 yrs Funds Lifecy 5-10 yrs Equity 10-20 yrs GICS MOnds Other Compan Unknown The Mechanics of a 401(k) An employee must first decide the amount to contribute, typically measured as a percentage of salary. EMPLOYEE 401(K) MUTUAL FUND 10%: Contributions are automatically deducted from your paycheck and, in a traditional 401(k) plan, the amount is not subject to tax. By deferring, say, 10% of your salary, you're also reducing your taxable income by 10%. 401(k) contributions are typically placed in mutual funds, which generally invest assets in stocks, bonds or money markets or cash. By deferring, say, 10 percent of your salary, you're also reducing your taxable income by 10 percent. The mutual funds are selected by your employer or plan manager. ADJUSTED GROSS INCOME Profits grow on a tax-deferred basis. 401(k) contributions can be made on either before- or Some employers also after-tax basis. match the amount an employee puts into the account or offer other incentives, such as profit sharing Traditional Vs Roth 401(k)s The main difference between a traditional and Roth 401(k) is in the taxation of contributions and withdrawals. 401(k): Your contributions are made on a pre-tax basis (i.e. they are not subject to tax). You pay tax on both the contribution amount and earnings when money is withdrawn. ROTH 401(k): Contributions are made on an after-tax basis. There is no additional taxation on withdrawals. In other words, your earnings grow tax free and can be withdrawn tax free, as long as you've held them in the account for a minimum of five TRADITIONAL 401() years and the account owner should be at least 59 /2 years old. ROTH 401(k) Not subject to taxes in the contributing year. Subject to federal and state tax in the year of contribution. IRS $10,000 IRS annual investment You pay $0 in taxes upfront on your $10,000 contribution, so your taxable income decreases by $10,000. Since you pay taxes on your $10,000 contribution, the contribution is considered taxable income. You pay $2,800 in taxes if you were in the 28% tax bracket, or a total of $84,000 for the next 30 years. O$10,000 O$10,000 contribution contribution Paid in taxes: 30 YEARS PASS $0 Paid in taxes: When you reach 59 1/2 and start to withdraw some money for retirement the amount that you are left with will differ again. $84,000 Required Minimum Distribution: A requirement that the balances of a 401(k) must be distributed aft age 70 1/2. $50,000 Traditional 401(k]s are subject to required minimum distribution. withdrawn ROTH 401(k]'s are subject to required minumum distribution. If you are still in the 28% tax bracket you would only keep $36,000 on a traditional 401k. OS36,000 withdrawn $50,000 withdrawn 30 YEARS PASS IRS Assuming you withdraw $50,000 a year for the next 30 years and continue to be in the 28% income tax bracket. Based on your rate of return over the 30-year period, however, you may deplete your IRS Since you paid income tax on your contributions, you owe nothing at the time of withdrawal. That makes all A ROTH 401(k) is a better choice than a traditional 401(k) if you account sooner. %24 expect to be in a higher tax bracket when you retire. earnings in your Roth 401(k) entirely tax-free. Paid in taxes: $ 420,000 Paid in taxes: $0 401(k) Limitations The IRS has imposed annual contribution limits for 401(k) plans. Those who withdraw money prior to turning 59 /2 will incur a 10% penalty on the withdrawals. There are some exceptions, including 401(k) rollovers and the Below are the limits that apply to 2011 contributions. situations illustrated below. LIMITS EXEMPTIONS $16,500 $6,000 (6%) Distribution to your estate or beneficiary after your death Medical expenses that exceed 7.5% of gross income $5,500 Permanetly disabled BILL PRE-TAX CATCH-UP LIMITS. Distributions made to the IRS to pay a levy on the plan itself, Distribution or dividends from employees stock ownership plans EMPLOYER CONTRIBUTION Certain divorce settlements IRS CATCH - UP LIMITS ARE LIMITED TO HIGHLY COMPENSATED THOSE WHO ARE AGES 50 EMPLOYEE Most plan sponsors can lend you money from the accumulated funds, but there are limits to the reasons for borrowing. HIGHLY COMPENSATED AND OLDER. EMPLOYEE There are some instances, such as For a highly-compensated employee, the total of your deferrals and contributions made by your employer to a 401(k) plan can be no more than 125% of the average deferral percentage (ADP) of all eligible financial hardship, where a withdrawl is allowed from you 401(k). FORECLOSURE non-highly compensated employees in a calendar year. Hardship Withdrawl: a permissable withdrawl due to certain financial hardships such as foreclosure. SOURCES: CNN Money, Investopia.com, NYTimes, psca.org, irs.gov mint.com Average Account Balance Percentage Share of Account %24