A 401(k) account is a retirement plan set up by an employer is to help employees build up their nest egg. During working years, the employee can contribute pretax dollars, which are not included in taxable income under IRS regulations until the money is withdrawn in retirement. While a 401(k) is a smart and effective way to save for your retirement, they come with a whole set of rules you should be familiar with if you're participating in one.
The different types of investment products available within a 401(k) account varies by employer. Some plans invest in the company itself, while others invest in a mix of products stocks, bonds and money market instruments. Often, the employee can choose the risk level at which they wish to invest. For example, a low-risk portfolio may include a small percentage of stocks, and a larger makeup of bonds and government securities. Contrastingly, a high-risk portfolio may contain mostly stock. Options vary by plan.
Employers can contribute matching amounts to a 401(k) plan up to a maximum limit of 3 percent of total salary. It's in the best interest of the account holder to contribute enough so that the company matches the maximum amount. Because the company is matching funds, this is essentially free money it's wise to get as much of it as you can.
Under IRS regulations, contributions to a 401(k) plan are tax-deferred, so the contributions do not show up on the taxpayer's W-2 form as taxable income. Wages contributed to a 401(k) plan are figured into total income earned for social security and Medicare taxation.
The IRS imposes a limit on the amount a taxpayer can contribute annually to a qualified 401(k) plan, and the limits are subject to change periodically. For 2011, the contributions limit is $16,500. However, federal regulations provide for leeway when an employee needs to make so-called catch-up contributions, and this can extend the maximum contributions allowed by several thousand dollars. The rules require that the employee must be age 50 or over to qualify for catch-up contributions.
In normal circumstances, an employee cannot withdraw funds from a 401(k) until retirement. However, if the employee switches jobs, becomes disabled or dies, the account can be liquidated. In addition, if the employee is a member of the U.S. military or National Guard and called to active service, funds can be withdrawn without a penalty. Once the employee returns to civilian life, the money can be returned to the account without a penalty.
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