Laws and Taxes Pertaining to Your Retirement - 401k
Written by Tina Phu, Yun Yang
Contributions To Your 401(k)s
Deferred wages (elective deferrals) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 since they were not included in the taxable wages on your Form W-2. However, they are included as wages subject to social security, Medicare, and federal unemployment taxes. You will be taxed on these deferred wages when you withdraw them out of your 401(k) plan at the time of retirement.
Withdrawals From Your 401(k)s
Distributions before the age of 59 ½ are subject to a 10% early withdrawal penalty, unless other tax exemptions apply.
When you withdraw money from your 401(k) account, you can't put it back. Different plans may allow you to take withdrawals for different reasons. The most common withdrawal type for active participants is the hardship withdrawal. According to IRS regulations, to qualify for this type of withdrawal, your hardship must “represent an immediate and heavy financial need and there must not be any other resources reasonably available to you to handle that financial need.” The IRS recognizes four reasons for a hardship
Payment of certain un-reimbursable medical expenses incurred by the participant, the participant's spouse, or any dependents
Cost relating directly to the purchase of a participant's primary residence (excluding mortgage payments)
Payments of tuition, related educational fees, and room and board expenses, for the next year of post-secondary education for a participant, the participants spouse, or any dependents
Payments necessary to prevent eviction or foreclosure on the mortgage of a participant's principal residence
Under the “Safe Harbor” plan, taking a hardship withdrawal will result in a minimum six-month suspension during which you will not be able to make contributions to your plan account.
Some plans also allow hardship withdrawals for other reasons. Check with your benefits department. You will need to show your employer proof of how you intend to use the money, and proof that the amount you requested isn't more than enough to satisfy your need.
Loans From Your 401(k)s
Many plans allow employees to dip into their account balances before retirement for emergencies or unexpected circumstances. One way to dip into your account for emergency use is by taking out a loan from your 401(k) account.
When you take a loan from your 401(k) account, you actually take money out of your account, with a promise to repay it.
Most 401k plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less.
You usually have up to five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.
Loan origination fees may exist and you can expect to pay anywhere from $25 to $100 just to process the loan.
The interest rate is often set as the prime rate plus 1%. The loans use a fixed rate and will be set on the day the loan is issued.
You pay your account back the balance you borrowed, plus interest (a fixed rate determined at the time of the loan), through after-tax payroll deduction.
As long as you repay your loan on time, you won't be subject to withholding taxes or penalties, as you would if you withdrew from your account before retirement.
Rollovers On Your 401(k)s
You have three options when you switch jobs:
You can roll your eligible rollover assets to and from 401(k), 403(b), and 457 accounts as long as your new employer’s plan accepts these rollovers. The benefit of being able to carry your 401(k) with you is that you would be able to consolidate all your employer-provided retirement plans, and your new employer’s plan may offer investment options different from your former employer’s plan. However, rolling eligible rollover assets requires time and paperwork.
You could keep your old account and start another retirement plan account with your new employer’s plan. You may avoid any potential hassles that occur when you roll eligible rollover assets. The benefit of opening an account with your employer’s plan is that the new employer’s plan may offer investment options different from your former employer’s plan.
You could roll over your old 401(k) plan to an IRA account, and then open a 401(k) plan with your new employer. The benefit of this plan is that through an IRA, you have more investment options. However, you would not be able to take a loan from the money you contribute to an IRA, you’ll have to keep track of two accounts, and you’d have paperwork to complete.
Note:Hardship withdrawals are not eligible to be rolled over, and are not subject to federal income tax withholding. You may still owe income taxes and a possible 10 percent early withdrawal penalty if you are under 59½ when you file your annual income tax return (unless you qualify for an exception to this rule). State and local taxes may also apply.
Bankruptcy Effects On Your 401(k)s
If your company’s creditors are going after your company’s assets, your employer-sponsored retirement plan and all funds in it are protected from these creditors since it is your asset. However, if you hold company stocks within your 401(k), you could face trouble.
If your company declares bankruptcy during the time your contribution is taken out of your paycheck but has yet to be deposited into your retirement plan, your contribution could get delayed in the bankruptcy proceedings. In this case, there isn’t much you can do but wait.
If you file for bankruptcy, your 401(k) should be exempt from creditors and is generally not part of the bankruptcy estate. These assets will stay with you through and after bankruptcy.
A 401(k) loan is not subject to the automatic stay and is not dischargeable in bankruptcy. This means that when you file bankruptcy, you have to keep making the 401(k) loan payments.
