3 Things to Know About Having a 401K

Until the 1980s, it was relatively common for employers to offer defined pension plans for their workers. This meant that an individual would know exactly how much he or she would receive in retirement, and the amount a person was given was generally based on years of service or performance metrics. Today, most employers offer 401(k) plans which do not offer a defined payout. Here are a few things that you need to know about them. 

Money Can Be Put In Before or After Tax 

Funds that are contributed to a 401(k) can either be placed in the account before or after taxes are removed from your paycheck. There are potential pros and cons of each approach. If you put money into an account before income taxes are removed, you lower your tax burden for the year. Income taxes on a contribution are paid in the year that a withdrawal is made. 

If you make a contribution after taxes are removed from a paycheck, you don’t get a tax break in the year that it is made. However, you do not owe any taxes on capital gains or other appreciation when you make a withdrawal. Regardless of when you put money in the account, it will grow tax-free while it is inside of it. 

Your Account Can Be Rolled Over If Necessary 

A 401(k) can be rolled over if necessary into either another similar account or into an IRA. For instance, if you changed companies, money accrued while working for a previous employer could be put into the new employer’s 401(k) plan if one is offered. However, if your new company didn’t offer a plan, you could choose to roll funds into an IRA where they would continue to grow tax-free. 

Of course, you can always choose to keep money in your current account if you are happy with its performance. In a divorce, funds from a qualified account such as a 401(k) may be transferred to a retirement account in your former spouse’s name. This would be done under the terms of a qualified domestic relations order (QDRO). 

If you are going to transfer funds from your 401(k) into another retirement account, it should be done through a direct rollover. This ensures that the IRS won’t see the transaction as a withdrawal, which could subject you to income taxes owed. If you are 59 1/2, you could be charged a 10 percent early withdrawal fee as well. 

You Can Designate a Beneficiary for the Account 

In the event that you pass before withdrawing the money in your account, the cash left over can be transferred to a beneficiary. Generally speaking, the beneficiary can be any person or entity who is eligible to receive funds in their own name. As minors can’t receive funds in their own name, it may be best to create a trust that is the beneficiary of the money. 

The trustee would then be responsible for ensuring that the minor obtained the funds upon reaching the age of majority in a given state. It is important to note that a beneficiary designation trumps the language of a will or trust. Therefore, it is important that the language in the designation matches that in a will or trust to ensure that your wishes are respected. 

A 401(k) account can be an effective way to save for retirement by those who are financially savvy. As a general rule, you should contribute up to the limit imposed by the IRS to get maximum compounding over your working life. This is generally a good idea whether or not your employer matches some or all of your contributions. It is also a good idea to keep plan documents and beneficiary designations where you or an authorized representative can access them easily.