Retirement Accounts at Work

By: Source: AARP.org Date Posted: 2006-02-02 15:17:46.440030-05:00

As traditional pensions are becoming less common, more and more employers are offering workers the opportunity to save with retirement accounts. A 401(k) plan is an example of a work-based retirement account. Here are some common types of plans:
  • 401(k) plans—private companies
  • 457 plans—public and non-profit sectors
  • 403(b) plans—education and non-profit sectors

While there are some differences, they operate in similar ways.

How Employer-Based Plans Work

Make the most of your retirement account at work so you can build a solid financial future. Here's how they work:

Sign up. You decide to sign up for your employer's retirement plan. Instead of that money coming home in your paycheck, it goes directly into your retirement account. You elect to postpone receiving a portion of your salary.

Contribute and reduce your income taxes. The money you put in the retirement account is not taxed in the year it goes into your retirement account. It is taken out of your pre-tax wages.

For example, assume that $100 goes into your account. The full $100 goes to work for you. But if you didn't contribute the money and kept it as "take-home pay," and you are in the 15% tax bracket, you would only see $85 of it after taxes.

Then, the money in the account grows tax deferred and is only taxed when you take it out.

Contribute the maximum. Be sure you know the maximum amount you can contribute in pre-tax dollars for your plan. In 2008, the maximum amount is $15,500.

Watch the Mission Retirement Video: It's Your Responsibility to learn why it's so important to take advantage of your employer work-based retirement plan.

Play catch-up. There are special rules to encourage people to catch up on their savings. If you're at least 50, you can put extra money in your retirement account in addition to the regular contributions. The maximum catch-up contribution for 2008 is $5,000.

Because your money grows tax-deferred in your 401(k) plan, don't invest in something that already grows tax-free in a regular account, such as a municipal bond. Instead, choose investments that would be taxed if in a regular account, such as a stock mutual fund.

Take advantage of the match. The most exciting part of employer-based retirement accounts is the matching contribution. Most employers will match a certain portion of the savings you put into an account.

This is free money that will help you reach your retirement goals. Don't pass it up!

For example, your employer may contribute 50 cents for every dollar you contribute up to a certain maximum, defined in the plan rules. So, if you contribute $1,000, you would actually have $1,500 put into your account.

Make good investment choices. Your employer chooses which investments are available in your plan. Try to pick investments that match your goal. Spread your investments around to reduce your risk. Become an informed investor.

Don't put all your money in company stock. Recent business scandals point up the importance in not putting all of your money in your company's stock. It is too risky.

Learn more about tax credits for low-income plan participants.

Vesting. When an employer contributes to your account, that money may not be yours to keep—that is, until you remain with the company for a certain period of time. Once you reach that time, the money becomes "vested;" it becomes yours to keep even if you leave the company the following day. Some employers have a graduated vesting schedule, which means that some percentage of the contributed money becomes vested each year you remain employed (until, of course, the money is 100% vested). Other employers have what's called "cliff vesting", which means that you're not entitled to any of the money until a certain length of employment—but then you're entitled to all of it from that point on.

Penalties. There are limitations on withdrawing money from these plans. Suppose, for example, that you just want to close out your account and blow the money. You will pay a 10% penalty on the amount distributed, plus the taxes on that money. There are a number of situations that allow you to avoid the 10% penalty (but not the taxes) on the withdrawal. They include:

  • You're at least 59 1/2;
  • Death;
  • Disability;
  • Qualified Domestic Relations Order (QDRO);
  • You're 55 or older and no longer an employee;
  • You're under 59 1/2, leave your job, and take substantially equal withdrawals based upon your life expectancy;
  • You have medical expenses not covered by insurance that exceed 7.5% of your income.

In addition, the employer is required by the IRS to withhold 20% of the withdrawal as an income tax payment. If, when you do your taxes, you are entitled to some or all of that money back, you will receive it in the form of a tax refund.

The power to borrow. Employer-based retirement plans may permit you to borrow the money in your account. Try to avoid borrowing from your retirement account unless you have to—it takes away from your goal of building a nest egg for retirement.

Here is how it works:

  • Generally, plan rules limit loans to no more than half of the vested amount in your account, up to a maximum of $50,000. There are other regulations that limit your loan, so you will need to check with your benefits department.
  • The plan may have other restrictions such as the size and number of loans. You may also be required to disclose your reasons for the loan.
  • In most cases, the loan must be repaid in full within five years.
  • As you repay the loan, the interest charged is credited to your account—so you're paying yourself the interest. This isn't always as good as it sounds. Removing money, even for a few years, can lead to your losing thousands of dollars in earnings over the long-term.

Emergencies. Most plans allow you to withdraw money without penalties (but not without income taxation) in the event of a financial emergency. Unlike a loan, you do not have to repay the withdrawal. Here are the conditions you need to meet in order to qualify for a hardship withdrawal.

  • You must have an immediate and severe financial need;
  • You can only take out the amount necessary to satisfy the financial need;
  • You have to document the financial hardship and prove that other sources of funding are not available;
  • You have to first use any other sources of funds, which are available in your plan, such as loans.

Hardship withdrawals may still hurt you. You may also be prohibited from making contributions again for six months or more.

The New Roth 401(k)s
Beginning in 2006, some employers may provide workers with the option of opening a Roth 401(k) account. In general, Roth 401(k)s operate by rules similar to traditional 401(k)s. Here are the main differences:

Contributions. Your contributions are subject to that year's income taxation. You can make up to $15,500 in contributions in 2008; and another $5,000 in "catch-up" contributions, if you're 50 or older.

Withdrawals. Withdrawals of contributions aren't taxed (that would be double taxation). Withdrawals of earnings aren't taxed either, if withdrawn after age 59 1/2 and it's been at least five years since you opened the account. Otherwise the earnings will be taxed, based on your tax bracket at the time of withdrawal.

Tax-free withdrawals can mean a significant increase in available retirement money; and the more years you have to invest until retirement, the larger the difference could be.

Early withdrawal penalties. Early withdrawal penalties. Withdrawals of earnings or contributions will face a 10% penalty if they occur before you're age 59 1/2.

Required distributions. Like 401(k)s, minimum distributions must begin the year after you turn 70 1/2; but unlike 401(k)s, you can roll over the Roth 401(k) into a Roth IRA if you leave your company. And once the money is in the Roth IRA, there is no required minimum distribution at any age.

Plans for Small Businesses

If you own or are part of a small business, you may be eligible for these retirement plans:

Keogh Plans. Keogh plans are for self-employed workers. These workers can use the Keogh to establish tax-deferred retirement plans for themselves and their employees. There's a limit to how much of your income and the amount of money you can put into a Keogh plan each year.

Simplified Employee Pension (SEP). These plans are designed for small businesses that don't have other pension plans. SEPs are tax-deferred retirement accounts. Business owners put money into their employees' SEP account. The employee then manages the account by investing the money.

Savings Incentive Match Plans for Employees of Small Employers (SIMPLE). Businesses with 100 or fewer employees can establish SIMPLE plans. Employees put a portion of each paycheck into an Individual Retirement Account (IRA). The employer makes matching or nonelective contributions. Employees then get to decide where to invest the money. They also get to keep their IRA accounts when they change jobs.

Take Action

Leaving a Plan

What happens to your money if you leave your job? A retirement plan account is portable, which means you're free to take your money with you. Be very careful here. Some people think of their retirement money as a windfall to be used when they're out of work or in need of some extra cash. It's a decision they usually regret later in life.

When leaving a company, you generally have three options:

1. Take cash. You can take all of your money in cash at any time. Think carefully before cashing out and using the money for another purpose—after all, this money is intended to build your financial security.

If you choose this option, your employer is required to withhold 20% and send it to the IRS as a prepayment on your income taxes (to protect the IRS from your spending it all and having nothing left to pay). So be prepared to receive 80%—not 100%—of the total amount you can take.

At tax time, you may also have to pay a 10% "premature distribution" penalty.

You can avoid the penalty if you:

  • are age 59 1/2 or older
  • leave the company and are over age 55
  • are under age 59 1/2, leave your employer, and take substantially equal withdrawals based upon your life expectancy
  • become disabled, as defined by your employer's plan
  • die, which means the money goes to your primary beneficiary (automatically your spouse unless you name someone else). If you want someone other than a spouse to receive your money if you die, be sure you've completed a beneficiary form.

If, at tax time, you owe more than the 20% already withheld, you'll have to pay the additional taxes out of your own pocket. If you owe less, the IRS will send you a refund.

2. Leave the money. Once you have at least $3,500 in your plan account, most employers let you leave it in that employer plan. You may want to do that if this plan has better investment options than the ones available in your new plan. You won't be allowed to add to your account, however. Before making your decision, be sure to find out if there are any administrative fees for non-employees that could negatively affect your earnings.

3. Roll over the money. To continue receiving the tax benefits of a retirement plan, you can transfer the money to another retirement plan—either your next employer's plan (if that's allowed by that company's plan) or an IRA (which you will open specifically for this purpose).

There are two ways to make the transfer:

  • Employer-direct. You can fill out a form and ask your former employer to transfer the money directly into another tax-qualified retirement plan with your new employer. Since the money never leaves the shelter of a retirement plan, you avoid the 20% withholding and the 10% early withdrawal penalty. This direct transfer is called a "rollover." There is also an automatic rollover requirement for eligible rollover distributions of more than $1,000. Under certain circumstances, if you do not make a choice to have the distribution paid directly to you or rolled over into another qualified plan, then the money will automatically roll over into a default IRA.
  • On your own. Even if you take it as cash (and your employer withholds 20%), you still have 60 days in which to transfer some or all of the money into an IRA (the 80% you received, plus the other 20%, which must now come from your own pocket). Whatever isn't transferred into your IRA may be subject to income tax and the 10% penalty.

Keep on rolling. If you open a "Rollover IRA" specifically to deposit your 401(k) money, the IRS will let you roll it over again into another retirement plan at a later date. So, for example, if you leave your employer, you can put your money in an IRA or your new plan, and when you get a new job, roll it over from the IRA into that employer's 401(k) plan.

Required Withdrawals. Generally, you have to withdraw a minimum amount of money each year once you've reached age 70 1/2 and are retired. (Actually, you have until April 1 following the year you turn 70 1/2.)

The amount is based on the life expectancy of a person your age and is equal to your account balance divided by the number of years you are expected to live. (If you are 70 1/2, for example, the IRS says your life expectancy is 16 years. So you'd divide your account balance by 16 to see the minimum you have to take each year.) If you withdraw less than the IRS minimum, you'll pay a 50% penalty on the amount you fall short.

To reduce your required withdrawals, you may be able to use the combined life expectancy for you and your spouse, rather than your life expectancy alone. Talk to a tax advisor for assistance.

Forward Averaging and Equal Periodic Payments. If you're at least 59 1/2 and withdraw all of your savings at one time (you take it in "one lump sum"), you may be able to take advantage of a special rule to lower your taxes. It's called "ten-year averaging" or "forward averaging," and it works like this:

You withdraw all of the money, but you're allowed to pay taxes as if you took it in equal installments over ten years. You are only eligible if you were born before January 2, 1936. Check with your tax advisor to see if you can do this and what effect it will have on your taxes.

Under age 59 1/2. If you're younger than 59 1/2, you may also avoid penalties and taxes if you take "substantially equal periodic payments" each year for your life (based on your life expectancy) or for the joint lives (joint life expectancy) of you and your designated beneficiary. Ask a tax advisor to help you.

AARP Resources

See a list of plan documents that can help you learn more about your plan.

Because your Money Matters, get more tips and action steps on 401k - PDF file

Additional Resources

The U.S. Department of Labor Web site features a host of information about defined contribution pensions. For a guide to SIMPLE and SEP plans, see the DOL brochure entitled "Simple Retirement Solutions for Small Business."

Learn about the tax implications if you inherit a 401(k) account at http://www.401khelpcenter.com/mpower/feature_2beneficiary.html.

Read more about Roth 401(k)s in SmartMoney.

Take this tutorial on SEP plans at http://www.investopedia.com/university/retirementplans/sepira.

For basic information on Keogh, SEP and SIMPLE plans, go to http://www.smartmoney.com/retirement/ira/index.cfm?story=taxfree.

The U.S. Department of Labor Web site features a host of information about defined contribution pensions. For a guide to SIMPLE and SEP plans, see the DOL brochure entitled "Simple Retirement Solutions for Small Business" at http://www.dol.gov/.

This column is meant to provide general financial information; it is not meant to substitute for, or to supersede, professional or legal advice.

Note: The content areas in this material are believed to be current as of this printing, but, over time, legislative and regulatory changes, as well as new developments, may date this material.

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