401k Rules To Remember

401k is a great way to save for retirement as long as rules that govern it are understood and followed to avoid unnecessary tax and penalty. Plans are mainly company sponsored and managed in accordance to IRS regulations but some rules are at the discretion of the sponsor and can be very specific, especially on fund withdrawals, such as loans taken out from a 401k account. 401k rules pertain to the entire plan process, ranging from participation requirement, contribution limits, withdrawal qualification, to plan rollover when ending one’s current employment.

Plan Participation

To be eligible for a 401k plan, the employee must have completed one year of service, has reached the age of 21, and does not have a collective bargaining agreement that already covers retirement benefits. And the rules do not exclude any older workers from the plan, as there is no age ceiling.

401k Contribution Limits

Employee contribution can be made either pre tax to a traditional 401k account or after tax to a 2006-enacted Roth 401k, or a combination of both. Because of the tax benefit given to 401k contributions, there are limits as to how much one can contribute yearly out of one’s total compensation. For both 2009 and 2010, the maximum individual limit is $16,500 in total for all contributions, including those made after tax, if any. Employees who are 50 years old or over are allowed an additional $5,500 catch-up contribution for 2009, which may be adjusted for inflation in increments of $500 for future years.

Employer matching contributions are an option rather than a mandate under the rules. If an employer elects to make matching contributions, the total amount contributed by both the employee and the employer in 2009 can not exceed $49,000 or 100% of the employee’s compensation, whichever is less. And the employer is allowed to make its contribution pre its corporate income tax.

Withdrawal Qualifications

Except for a few exceptions, withdrawals generally can not be made before the age of 59 and half without incurring a 10% excess tax penalty on the amount withdrawn. All withdrawals, early or qualified, are subject to the normal income tax unless they are from a Roth 401k or the principal contribution amount made after tax, excluding any earnings generated.

To qualify for a penalty-free, early withdrawal, one must:

1. have a qualified tax-deductible medical expense, defined as part of the total unreimbursed medical expense that exceeds 7.5% of one’s adjusted gross income
2. have become totally and permanently disabled
3. have a domestic relations court order that demands fund withdrawals for one’s divorced spouse, a child, or a dependent.
4. be 55 years old or over and have entered an early retirement.
5. have been already retired as of March 1, 1986 and still be in retirement currently and have elected to start receiving substantial equal periodic distributions of 401(k) balance, which must last at least 5 years or until 59 and half, whichever is longer.

Early withdrawals are generally not encouraged regardless of paying a penalty or not. Some non-qualified early withdrawals in the form of hardship withdrawal may be permitted under conditions prescribed by the rules:

1. The financial need is immediate and severe.
2. No other funds or ways to meet the need.
3. Other early distributions have been first obtained.
4. The amount withdrawn is not exceeding the amount needed.

To qualify for hardship withdrawal with penalty assessed, funds withdrawn must be used to cover:

1. non-tax-deductible medical expenses that are not reimbursed
2. payments related to the purchase of one’s principal residence
3. funds used to prevent eviction or foreclosure
4. higher educational costs, i.e. tuition and room and board
5. expenses for the repair of damage to one’s principal home
6. funeral expenses for a family member

401k Loans

Depending on plan sponsors, some offer a 401k-loan option to accommodate the needs of early withdrawals by plan participants. Such a loan is made available before any hardship withdrawals. Unlike other early withdrawals, a loan taken out from a 401k account incurs neither a penalty nor the income tax, as long as it’s paid back to the account. The maximum amount of the loan is the lesser $50,000 and 50% of the account’s vested balance. The loan term is normally less than 5 years unless when used for a home purchase. The repayments of the loan is made with after-tax income, resulting in double taxation on future withdrawals. When leaving the company, the loan must be paid back in full in 6 days to avoid the 10% penalty. Any other default during the term of the loan also triggers the penalty.

Mandatory Withdrawal

Required minimum distributions must be made by April 1 following the year one turns 70 and half . If you fail to take a RMD, there is a 50% penalty on the amount that should have been distributed.  That’s a huge penalty, so be sure to stay on top of your RMDs.

401k Rollover

Because 401k is tied to your employer, when you change jobs or return you can rollover your 401k to another retirement account (preferably an IRA). If the transfer is made between sponsors, referred as direct rollover, it’s free of any tax or penalty.

Understanding the 401k rules allows you to take advantage of the generous tax savings, produce the most possible investment earnings by making less interrupting withdrawals, and importantly avoid unnecessary penalty. The rules governing 401k are the essential road map to a successful retirement savings and investments.