What is 401 (k) plan? How it works? What are the restrictions?

401k plan rules and restrictions

What is 401 (k) plan?

401 (k) plan is most common type of retirement savings plans. This plan is offered to employee through his/her employer, that is, your employer sets up a retirement plan for you. With 401 (k) plan, you are allowed to choose between taking compensation in cash or deferring a percentage of it to an account under the plan.

401 (k) plan lets employees save and invest some part of their paycheck before taxes are taken out. You will not pay taxes until you draw the money from the account.

How 401 (k) plan works? What are the restrictions in 401 (k) plan?

  • Before paycheck is taxed, employee contributions are automatically deducted from paycheck. That is, you decide how much you want to contribute, and your employer puts the money into your individual account on your behalf.
  • When you retire, the money you have in the account is available to support your living expenses during your retirement.
  • The contributions are directed to the funds in employee’s selected retirement plan. A 401(k) plan usually offers five or more mutual funds that invest in various sectors of the financial markets.
  • Your employer is plan sponsor, but it hires another company to administer the plan and its investments. Your employer sends your paycheck deductions directly to the company managing your plan.
  • Although not required to by law, many employers match a portion of the contributions employees make to their 401(k) account. For example, if your company matches 0.5% for every 1% you contribute up to 6%, that translates into an extra 3% in your account if you take advantage of the entire match. That is you receive free money for your retirement, however, you will take this free money in some certain specific rules put by your employer.
  • When you draw money from your account before retirement, it will be subjected to taxes. But since you’ll be retired, you’ll possibly be in a lower tax interval.
  • When you may want to take money before retirement, you will face some penalties. If you’re younger than 59½, also may owe a 10% early-withdrawal penalty. Plus, the IRS requires your employer to withhold 20% of your account value to pre-pay at least part of the taxes you’ll owe.
  • You can defer in 2016 up to $18,000 or 100% of compensation, whichever is less. Employees age 50 and over can make additional “catch-up” contributions of $6,000 in 2016.
  • Employees who retire any time during the calendar year in which they turn 55, or later, are not subject to the 10% penalty.
  • 401k plans may permit “self-directed investment accounts” and company stock purchase within the plan.