Getting Familiar with 401(K).

What is 401(K) Plan?

401(K) is the employer sponsor plan (defined contribution plan) that allows individuals to contribute cash (a maximum of $17,500 for 2013), share in stock options, or reduce salary compensation. Individuals can control how much money they invest into 401(K). Usually, the contributions to 401(K) are divided into stocks, bonds, and money market mutual fund investments. In the salary reduction form of 401(K), individuals agree to have their employer withdraw a certain percentage of their salary income. The contribution made by employers from the salary income of the employees is invested into their 401(K). However much money a person invests is tax deferred, with the limit being $17,500. Individuals do not have to pay taxes until the amount is withdrawn. But if taxpayers decide to withdraw from their 401(K) before the age of 59 ½, then they are subject to additional 10% penalty taxes.

Benefits:

            In most cases, the employer matches the amount that an individual contributed in 401(K) plan. For example, if a taxpayer has contributed 5% of his total salary, then the employer will contribute another 5%. This is called 100% match from the employer. Getting a loan from the 401(K) retirement system is another way for taxpayer escaping from the penalty of 10%. When someone takes a loan, the interest paid made will go back into his 401(K) contribution. For example, if a taxpayer takes a loan of $1,000 from 401(K) retirement system, then he will pay interest of $100. Then the excess amount paid, a $100, will go into his contribution of 401(K) plan, which means a taxpayer is paying interest to himself. However, if a taxpayer goes into default on his loan payment, then the loan is considered as distribution and is subject to a 10% penalty. The 401(K) plan is protected against job changes. If a taxpayer ever decides to change his job, then the amount contributed to his 401(K) plan can be carried to his new place of employment. In addition to this, , money invested in the 401(K) is not subject to bankruptcy  This simply means employees are protected from creditors.

Practical Implication:

Suppose Wilbur makes $50,000 per year once he graduates. He should try to contribute the maximum$17,500 to his 401(K). In this way, he will benefit financially. The $17,500 will be pre-taxed money. Suppose his employer will match 3% of his salary, and his employer matches 50 cents for every dollar for the next 2% of his salary. Then, his total amount of contribution to his 401(K) will be $17,500 + $50,000*.03 + $50,000*.02*.50 = $19,500. Also, in the case of a financial emergency, he should utilize his 401(K). He should take the loan from his 401(K), so that he will pay interest to himself. This contribution in 401(K) will also help him decrease his marginal tax rate, which could give him additional savings.