401(k) Frequently Asked Questions


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  1. Do I have to pay taxes on the money I contribute to a 401(k) plan?
  2. What are the tax advantages of participating in a 401(k) plan?
  3. What's the difference between taxable, tax-deferred and tax-free investing?
  4. What are the different kinds of tax-deferred investment vehicles?
  5. Will my Social Security benefits be affected by my 401(k) plan distributions?
  6. Will I have to pay taxes on my 401(k) plan if I leave my company?
  7. Can I make after-tax contributions to my 401(k) plan?

1. Do I have to pay taxes on the money I contribute to a 401(k) plan?

Your pre-tax 401(k) contributions are deducted from your pay before federal income taxes are withheld. You don't pay federal taxes on this money until you withdraw it from your 401(k) account.

However, you are required to pay Social Security tax on all 401(k) contributions.

As for state income tax, most states exempt 401(k) contributions from taxation, but depending on where you live your contributions may be subject to local income taxes.

You should check with your company's Human Resources or Benefits representative regarding the laws in your area.

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2. What are the tax advantages of participating in a 401(k) plan?

There are three primary tax advantages to participating in a 401(k) plan. They include:

  1. Lower Income Taxes: Because your 401(k) contribution is deducted before taxes are taken out, you're be taxed on a smaller sum of money, which makes your initial tax hit lower. An example: if you earn $30,000 per year and are in the 28 percent tax bracket, your federal tax liability for the year is $8,400. Under that same scenario, if you contribute 10 percent of your salary ($3,000) to a 401(k), your taxable income is decreased to $27,000. At a 28 percent tax rate, your federal income tax liability will be $7,560 -- that is $840 less than you'd pay if you didn't contribute to a 401(k).
  2. Increased Investing Power: Pre-tax investing increases your investing power by enabling you to save more. In the example above, a 10 percent 401(k) contribution from a $30,000 salary is $3,000. Ten percent of your after-tax income, on the other hand, comes to less than $2,200. Contributing before taxes enables you to save an extra $800.
  3. Tax-Deferred Compounding: Since you don't pay taxes on your 401(k) contributions or subsequent earnings until you withdraw money at retirement, your savings accumulate faster. Say you contribute $2,000 per year to your 401(k) for 40 years, and your investment earns an annual return of 8 percent each year. At the end of the 40 years, you will have contributed $80,000 to your 401(k), but your account will be worth $518,113 -- thanks greatly to the power of tax-deferred compounding.

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3. What's the difference between taxable, tax-deferred and tax-free investing?

A taxable investment is one in which you pay taxes every year on the dividends and appreciation of investments that you sell. A simple example of a taxable investment is a regular savings account. Every year when you file your tax return, you're required to report the interest your savings account has earned and pay taxes on it. Here's a good rule of thumb: any time you buy a stock, bond, mutual fund, money market account, etc., that is not part of a special tax-sheltered account (such as a 401(k), 403(b), IRA, etc.) it is most likely a taxable investment, and you'll be required to pay taxes on its earnings every year.

A tax-deferred investment is one in which you do not have to pay taxes on the investment's earnings until you withdraw money from the account. Examples of tax-deferred investments include 401(k), 403(b), and IRA accounts. In many cases, contributions you make to tax-deferred accounts are partially, if not completely, tax deductible. Because tax-deferred accounts are designed to help people save for specific goals -- such as retirement or a child's education -- there are hefty penalties attached to withdrawing your money from the account too soon.

A tax-free (or tax-exempt) investment is one in which you don't have to pay taxes on the income the investment earns. A municipal bond is an example of a tax-free investment. Note however, that just because an investment is called "tax-free" does not mean that you won't have to pay any taxes on it. Some tax-free investments are exempt from only federal income taxes, while others may be exempt from only state or local taxes.

There is one investment that is both tax-deferred and tax-free, the Roth IRA. You contribute after-tax money to this individual savings account, but your money grows tax-deferred and you don't pay income tax on the money (not even the earnings) when you withdraw it.

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4. What are the different kinds of tax-deferred investment vehicles?

New tax laws in recent years have increased the number of tax-deferred retirement accounts available. Because of the various rules governing eligibility, you should consult a professional tax advisor when deciding which of the following options best suits your situation.

  • 401(k) -- You may make pretax contributions of up to $11,000 in 2002, and your employer may contribute additional matching funds. You earn compound interest. Applicable taxes must be paid when money is withdrawn, and there is a 10 percent penalty for early withdrawal (before 59, or 55 if you leave your job).
  • Traditional IRA -- You may contribute up to $3,000 in 2002. Whether these contributions are tax deductible depends on whether you participate in a 401(k) and what your income level is. You earn compound interest on the money in the account. Applicable taxes are due when money is withdrawn, and there is generally a 10 percent penalty for early withdrawal (before 59) of pre-tax contributions and the account's earnings.
  • Roth IRA -- You may contribute up to $3,000 in 2002. Contributions are not deductible, but interest grows tax-free and you pay no tax upon withdrawal. If your gross income is over $160,000 for joint filers or $110,000 for single filers you may not contribute to a Roth IRA.
  • Spousal IRA -- If you do not have earned income but your spouse does, you may contribute up to $3,000 to a spousal IRA in 2002, even if your spouse is covered by a 401(k) plan at work. Whether contributions are tax-deductible depends on income level and participation in an employer-sponsored plan.
  • SIMPLE IRA -- A SIMPLE IRA works a lot like a traditional IRA except that you can contribute more (up to $7,000 in 2002) and employer matching contributions are allowed. A self-employed person can contribute $7,000 as an individual, and his company can match his contributions dollar-for-dollar, for a total annual contribution of $14,000. Another plus, the SIMPLE plan you set up now can grow with your company. Employers with 100 or fewer employees can use this plan.
  • SIMPLE 401(k) -- A SIMPLE 401(k), a variant of the SIMPLE IRA, works much like the SIMPLE IRA with a few notable exceptions. On the downside, it requires a lot more reporting and administration than a SIMPLE IRA does. On the upside, a SIMPLE 401(k) allows for hardship withdrawals and loans. A SIMPLE 401(k) can be set up for companies with 100 or fewer employees. The maximum salary deferral allowed per employee in 2002 is $7,000 or a percentage of salary specified by the employer, whichever is less. The employer must make either dollar-for-dollar matching contributions up to 3 percent of compensation for each employee (for a total employer and employee contribution of up to $14,000), or non-elective contributions of 2 percent of compensation on behalf of each eligible employee who receives $5,000 or more in compensation from the employer.
  • Simplified Employee Pension IRA (SEP-IRA) Plans -- SEP plans are essentially individual retirement accounts (IRAs). The money you contribute to a SEP-IRA is tax-deductible and your investment earnings grow tax-free until you withdraw funds at retirement. For 2002, if you are the only participant in the plan, you can deduct contributions of up to 25 percent of your compensation or $40,000, whichever is less. If you have employees, in 2002, they may contribute up to 100 percent of their compensation or $40,000, whichever is less.
  • Keogh Plans -- If your business is not incorporated, you may be eligible to establish a Keogh plan. Keogh plans are generally more flexible than SEPs and may allow you to save even more toward your retirement than you can in a SEP plan. For 2002, you can save up to $40,000 a year in combined employer and employee contributions in a Keogh. Keogh plans must be set up as either a defined-contribution plan [like a 401(k) or SEP] or as a defined-benefit plan (like a traditional pension). In other words, you will need to have a plan document. For that reason if you're considering a Keogh plan, you may want to seek the advice of a pension professional.
  • 403(b) plans -- These are similar to 401(k) plans, and are sometimes referred to as "401(k)s for non-profits" because they are commonly used by non-profit institutions like hospitals, public school systems and charitable organizations. Many of the rules governing 403(b) plans are similar to those for 401(k) plans. These plans offer a choice of investment options, often permit loans and may have an employer matching contribution. For 2002, the maximum annual contribution to a 403(b) plan is $11,000.
  • 457(b) plans -- A tax-deferred savings plan offered to employees of state and local governments. (A different type of 457, the 457(f) is sometimes offered to top-level management in tax-exempt organizations and has different rules.) The maximum contribution to a 457(b) in 2002 is $11,000 (unlike 401(k) plans, this limit includes both employer and employee contributions). The limit in 2001 was $8,500. Some 457 participants are eligible to make additional "catch-up" contributions when they are within three years of retirement.

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5. Will my Social Security benefits be affected by my 401(k) plan distributions?

Not necessarily. Having a 401(k) will not reduce your Social Security benefits, but distributions from your 401(k) taken during retirement may make your Social Security benefits subject to federal income tax, especially if you have significant other income.

If you are concerned that retirement savings distributions might affect your Social Security benefits (or the taxation of those benefits) you should consult with your tax advisor, attorney, or CPA regarding your own unique situation.

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6. Will I have to pay taxes on my 401(k) plan if I leave my company?

That depends on what you decide to do with your 401(k) money. You have several options:

  1. Leave the money: If your vested account balance is $5,000 or more and you're under the plan's normal retirement age, which is commonly age 65, you can leave your money where it is -- and taxes won't be due until you withdraw money from the account. However, if your balance is less than $5,000 and more than $1,000, your employer may decide to automatically roll it into an IRA account on your behalf. If this occurs, there are no tax consequences because the money is moving from one tax-deferred account to another.
  2. Roll the money into a new plan or IRA: You can roll over your 401(k) into a rollover IRA account or into your new employer's 401(k) plan. If you do a direct rollover -- have the money transferred directly into the new account -- you won't owe taxes until you withdraw money from the account.
  3. Cash out: If you elect to take your money out of the 401(k) and not roll it over into a rollover IRA or another employer-sponsored retirement plan you will owe all applicable taxes. You will also owe a 10 percent early withdrawal penalty unless you leave your company during the year you turn 55 or later.

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7. Can I make after-tax contributions to my 401(k) plan?

You can, but it may not be the most advisable course of action. Take a look at the following comparison between pre- and post-tax 401(k) contributions. By the way, not all employers permit after-tax contributions to their 401(k) plan. Check your Summary Plan Description to find out if after-tax contributions are allowed.

Pre-tax Contributions:

Both the contributions you make to your account and the investment gain continue to grow tax-free until you withdraw money from your account at retirement.

As you take money out of your 401(k), you pay taxes only on the amount you withdraw (so that at retirement, taxes don't come due on your entire account balance at once).

Because your 401(k) contribution is deducted from your compensation before taxes are calculated, your taxable income is lower, so you pay less income tax.

If you withdraw money from your 401(k) account before age 59 you will generally have to pay a penalty. The penalty will not apply in the cases of a qualified hardship as defined by the IRS, if you take early retirement starting in the year you turn 55, or if prior to turning 55, you take withdrawals based on a series of equal periodic payments as defined by the IRS.

Post-tax Contributions:

Because post-tax contributions are made with money you've already paid taxes on, only the investment's gain or income (i.e. interest and dividends) -- and not your contributions -- enjoy the benefit of tax-deferred growth.

When you withdraw post-tax 401(k) funds you only pay taxes on the gain (interest or dividends) your investment has earned. As with pre-tax contributions, taxes are due only when you take money out of your account.

Post-tax contributions are not tax-deductible, so you don't get a tax break for making them.

Depending on your plan's rules, you may be able to withdraw your post-tax contributions at any time without incurring a penalty. However, because the gain you earn on your post-tax 401(k) investment is tax-deferred, you must pay income tax on that amount when you withdraw your money. The gain is also subject to an early withdrawal penalty if withdrawn before age 59. The penalty will not apply in the cases of a qualified hardship as defined by the IRS, if you take early retirement starting in the year you turn 55, or if prior to turning 55, you take withdrawals based on a series of equal periodic payments as defined by the IRS.

Now, considering that the best tax break and the greatest opportunity for taking advantage of tax-deferred compounding come with pre-tax 401(k) contributions, why would anyone consider making post-tax contributions?

Here are some possible scenarios:

  • If you are already making the maximum pre-tax 401(k) contribution allowed and really want to contribute more (to get the benefit of tax-deferred investment growth).
  • If your employer matches both pre-tax and post-tax contributions, and you are fully vested for matching contributions, you might choose to maximize the employer match by making the maximum allowable pre-tax contribution and making post-tax contributions as well.
  • If you are committed to saving money, but aren't sure you'll be able to leave your money invested until retirement, you might make after-tax contributions because you will be able to withdraw them without penalty before age 59. A person considering this idea needs to remember that the gain earned on the investment is subject to an early withdrawal penalty if taken out before age 59. Also, income tax on the investment gain is due at the time of withdrawal.

The 401(k) is an investment vehicle for retirement. If retirement is not the goal, there is probably a more appropriate vehicle for post-tax investment dollars.

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