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Sunday November 19, 2017
401(k) Retirement Plans
The 401(k) is rapidly becoming the most popular qualified retirement plan. More than 90% of large companies now offer a 401(k). With a 401(k), each employee has an individual account and is permitted to transfer a portion of his or her salary directly into the account each year.
Most 401(k) plans qualify for excluding the contribution from your taxable income each year. However, some employers have created a "Roth 401(k)" plan in which your contributions are after tax.
To encourage employees to fund a 401(k), some employers also create a matching fund. The employer determines the amount of match and the maximum. While many different plans are selected by employers, a fairly typical employer match is $1 for $2 of contribution to 6% of the employee's salary. With this plan, an employee who contributes the full 6% would receive a 3% employer match. Therefore, the total 401(k) contribution that year would be equal to 9% of the employee's income.
There are several potential contribution limits for employees. This year, the voluntary contribution by the employee is limited to $18,000. However, employees over age 50 during the year are permitted to add a "catch up" contribution of $6,000. The total annual employee contribution for those over age 50 is $24,000 this year. Both limits are indexed for inflation and increase in $500 increments. Some companies also will add a match or other company contribution to that amount.
Most companies have highly compensated employees (HCE) who are subject to specific rules. To make certain that the contributions are fair, the employees with income above a certain threshold and owners of more than 5% of a business are limited in their contributions. There are various "safe harbor" provisions that allow the HCEs to contribute without worrying about the annual contribution tests. For example, if there is a non-elective contribution by the company of 3% or more for all employees, then the plan does not have to meet specific standards for highly compensated employees.
The employer will select a custodian of the 401(k) and typically there will be a group of mutual funds for the 401(k) investments. The employee will have opportunity to select from the various mutual funds. These mutual funds are usually in four general categories.
The first category is stock mutual funds. Stocks have a long-term return of approximately 10%. For investments of 20 years or more, a percentage of the 401(k) in stocks will usually be a good decision. Stock funds generally include large cap, medium cap and small capitalization companies. Some funds may favor domestic companies and some foreign.
Stock funds should be fairly diversified to minimize the risk of loss if a company were to fail. A portfolio of large, midsized and small company mutual funds may own shares in 1,000 or more companies.
Bonds are the second type of investment fund. Mid-term and long-term bonds have returned approximately 5.5% during the past 75 years. Because bond values change much more slowly than stock values, the bonds are a more stable investment than stocks and are appropriate for shorter timeframes before retirement. As 401(k) owners move into their 50s, 60s and 70s, the percentage of bonds normally increases and that of stocks decreases. Some advisors suggest that the percentage of bonds should match your age. For example, a person age 60 may choose to hold 60% in bonds and 40% in stocks.
Cash is the third investment option. Most 401(k) plans permit a money market fund or similar option. Returns on cash funds are frequently 1% to 3%, but these cash options preserve principal in a downturn.
Real estate is the fourth investment type. Some 401(k) plans permit real estate investment trust (REIT) investments. Real estate may be a good long-term investment, but also involves substantial potential risk.
There are three general periods of time of importance to 401(k) owners. Prior to age 59½, there is a 10% excise tax on distributions. For a regular 401(k), the owner who takes early distributions would pay both income tax plus the additional 10% excise tax. There are exceptions for disability, substantially equal payments over a lifetime or economic hardship, but most individuals attempt to avoid early withdrawals if possible.
Between age 59½ and age 70½, there is a voluntary distribution option. As a 401(k) owner, you may choose to take distributions to cover living expenses. The distributions may be any amount from the regular 401(k), but will be reported by you as taxable income.
After age 70½ (by April 1 of the following year), you must take at least the required minimum distribution (RMD). Your required minimum distribution starts at approximately 3.8% at age 71 and increases to nearly 8.8% by age 90. With one exception, the distributions by a 401(k) owner are governed by this schedule under the IRS Uniform Table. The exception is a husband and wife in which one spouse is more than 10 years younger. A special table applies in that case.
A 401(k) plan document may permit you to take a loan from your account. Loans are limited to the lesser of 50% of your plan or $50,000, and must be repaid within five years (except for purchase of a primary residence). A reasonable rate of interest is charged. While your loan is repaid with after-tax dollars, your 401(k) account will grow by the amount of the loan interest.
Because the required initial withdrawal amount at age 71 is approximately 3.8%, many individuals with 401(k)s will find that their total fund balance increases until their early to mid 80s. Even with some reduction in balance during ages 85 to 95 because the withdrawal percentages continue to increase, many 401(k) owners will pass away with substantial balances.
Because there is likely to be a significant balance in your 401(k) when you pass away, careful selection of your designated beneficiaries is important. If you pass away with a substantial 401(k) balance, then a significant amount will be distributed to your designated primary or contingent beneficiary. In most cases, your designated beneficiary will have the option of taking distribution of your 401(k) over a term of years.