Taking part in a 401(k) plan provides you with a jump on your long-term financial protection. Not only does a 401(k) offer you a method for saving, but it also lets the money in your account to grow tax-deferred. This implies that the sooner you start to take part in a 401(k) plan and the more you contribute, the better probability you will have of accumulating a significant retirement account. However, it is not a foregone conclusion that your 401(k) investments will earn you a specific percentage annually. Your account may decline in value in a down market. And if the investments that you select don’t yield the average return, at best, in a strong market, you may accrue less than you expected.
You have to meet the requirements to participate prior to signing up with a 401(k) plan. Federal law insists that when an employer promotes a plan, all employees need to have a level playing field to save for retirement. Your employer can institute two limits. The first is that you have to work for a full year and the second is that you must be at least 21 years of age before you join. However, not every employer requires you to wait. One of the inquiries you should make when you are evaluating a new job is when you will be likely to contribute to a 401(k).
401(k) plans are evaluated to ensure that they concur with suitability, contribution, and additional stipulations, and that employers don’t discriminate against employees with lesser salaries. The Pension Protection Act of 2006 gives employers a new nondiscrimination testing safe harbor. Plan sponsors are able to avoid nondiscrimination testing as long as they utilize automatic enrollment and satisfy requirements pertaining to default investment alternatives, contribution and growth rates, vesting and employee communications. Nondiscrimination testing guarantees that employers regard all employees justly and fairly, and promote widespread participation. If a 401(k) plan is determined to be discriminatory, it could be penalized or maybe even terminated.
When you join in a 401(k) plan, you enable your employer to retain a specific percentage of your total wages or a particular dollar amount every pay cycle and commit it to an account that has been created in your name. Generally, your employer has to put your contributions into your account within 15 business days after the end of the month in which the money is discounted from your pay. Those payments should appear on your 401(k) statements. Employers have more freedom in adding any matching contributions they invest to your account. The matching contributions may actually be made as seldom as once a year. You can increase or decrease your contribution rate as many times as your employer allows you to, whether it be only once during the year, or more frequently. For instance, if you get a raise, you may come to a decision that you may be able to commit more toward retirement and increase the percentage you’re contributing.
Because your contributions to a traditional 401(k) are tax deferred, they decrease both the total on which income taxes are withheld each pay cycle in addition to your taxable income for the year. 401(k) contributions are however incorporated in the total on which FICA taxes for Social Security and Medicare are calculated. In contrast, contributions to a Roth 401(k) are not tax deferred. Therefore, they don’t decrease current income taxes, but withdrawals will be tax free if you are at least 59½ years of age and your account has been open at least five years.
When figuring out how much of your pretax income you should contribute to your 401(k) plan, you must abide by two sets of restrictions. The ones imposed by the federal government and the ones imposed by your employer. The government limits your annual contributions at a dollar amount, which in 2009 was $16,500 and if you were 50 years of age or older you could make an extra $5,500 contribution for a total of $22,000. The limits for 2010 remain the same as in 2009. The annual contribution is raised regularly to show increases in inflation. Your employer may restrict your contributions to a percentage of your salary. You typically contribute a percentage of your compensation, or pay, to your 401(k). Based on your job, your compensation may comprise of salary, wages, overtime, commissions, and fees for professional services. Generally, that limit is 10 or 15 percent of your total income earned, although it may be more or less. You can not contribute more than the percentage of your pay that your employer allows you to add to a 401(k) every year, despite the fact that this may signify that you can deposit less than the limits set by the government. On the opposite end of the spectrum, your employer may ask for a minimum contribution of 1 or 2 percent from any employee who wants to enroll in the plan.
Individual 401(k)s let you to defer salary up to equal the contribution restrictions of other 401(k)s. Furthermore, your business, as your employer, can contribute up to 25 percent of your salary. The combined limit for 2009 was $49,000, plus the catch-up contribution of $5,500 if you are 50 years of age or older. The combined limits for 2010 remain the same. If you have set up a SEP-IRA, which is another retirement plan that’s available to sole owners and other small businesses, you cannot defer salary or make a catch-up contribution, but your company can contribute up to 25 percent of your salary to a limit of $49,000.
Another contribution restriction you might encounter is if you are regarded as a highly compensated employee (HCE) for 2010. For 2010, an HCE is any person who was a 5 percent owner at any time during 2009 or 2010 or anyone who received more than $110,000 in compensation during 2009 and, if chosen by the employer, is in the top twenty percent of employees based on compensation. The HCE limit for 2008 was $105,000 and $110,000 for 2009. This signifies that the maximum you can contribute to your 401(k) account hinges on the average that all non-highly compensated employees (NHCE) are either contributing to their 401(k) plans in the current year or have contributed in the prior year.
Even though your pretax contributions to a traditional 401(k) plan are restricted, you may be able to make an after-tax contribution to your account if your employer’s cap is greater than the government’s cap. The total you could be qualified to add is the disparity between the government’s limit and the total you would have been able to contribute depending on the percentage of compensation your employer allows. A benefit of investing after-tax contributions to a traditional 401(k) is the possibility to create a bigger retirement savings account. But combining pretax and after-tax money in the same account may confuse the tax outlook when you are prepared to withdraw from your 401(k) account or roll it over.
A surplus contribution is not the same thing as an after-tax contribution. You have made a surplus contribution when you contribute more income than is allowed for the year. This might occur if you are given a raise and don’t remember to reduce your contribution rate. If you don’t take the extra money out before the year is over, you will have to pay a 10 percent penalty. A matching contribution is money that your employer adds to your 401(k) account on top of the total you defer from your compensation. You don’t pay income tax on matching contributions; they are not included in your contribution restriction. They multiply tax deferred, the same as your own contributions do.
Your employer may match a portion or all of your 401(k) contribution. Matching isn’t mandatory, but many employers adapt it to appeal to employees, promote plan enrollment, or take advantage of the tax deduction it gives them. Your employer decides how the match is measured and if to contribute cash or shares of company stock. One method is to match 50 percent of what you contribute to a particular percentage of your earnings, typically 5 or 6 percent. Another method is to match your contributions to the dollar amount to a particular percentage of your earnings, which is once again, typically 5 or 6 percent. You meet the requirements for matching by taking part in your employer’s 401(k) plan. One of the most effective arguments for making your own contribution is that you will qualify for the matching contribution. Another method your employer may use to add money to your 401(k) account is as part of a profit-sharing plan. In these plans, your employer shares the company’s profits with every employee for each year that profits are made.