Editors’ pick: Originally published Jan. 7.
The market’s horrific sell-off this week is making a lot of investors nervous about the security of their retirement money. As you gird for a tumultuous new year, now’s a good time to review a few common facts about 401k plans.
Over time, the effort you invest today can add up to thousands of dollars in your nest egg.
What are the limits to 401k contributions?
This question is trickier than it seems. You can’t just determine the limit and then assume the ceiling is fixed. As with anything that involves the government, the rules continually change and you need to monitor them.
The maximum pretax contribution dollar amount is established by federal law and annually adjusted for inflation. The 2015 pretax contribution limit is $18,000.
How much should I contribute?
We advise the maximum, but that’s easier stated than done. Not everyone can afford it. Strive for at least 15%-20% of your income during your earning years.
If your company is generous enough to offer a matching contribution, you should kick in enough to make the most of that match. For example, if your company matches $1.00 up to 10% of your contributions, you should contribute at least 10%.
Are there different ways in which employers offer a matching contribution?
Yes, your employer can choose among several methods for determining the percentage that it contributes. The most common are a fixed percentage of what you put into the plan; a predetermined percentage of your pay; and a discretionary percentage that’s subject to change according to how your company is performing.
To reiterate: Make it a point to contribute at least the minimum amount required to trigger your company’s full match. Otherwise, you’re refusing free money. It’s a wealth-building tactic that should be part of your long-term investment strategy.
I’m self-employed. What are my 401k options?
Many people don’t realize that you don’t need to run a large full-time business to benefit from a self-employed retirement plan. Even if you moonlight, work part time, or freelance, self-employed retirement plans offer enormous tax benefits.
In fact, if your cash flow can handle it, you might be able to put 100% of your net profit as a self-employed person into a 401k plan-and deduct the money, too. Here’s a look at your best option:
- Simplified Employee Pension (SEP) Plan.
If your income from self-employment is relatively small, or if you’re newly self-employed, a SEP is your best bet.
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The biggest enticement of a SEP is as its name implies: it’s simple. The Internal Revenue Service treats a SEP just as if it were an Individual Retirement Account (IRA), which means the paperwork to set up a SEP is minimal and, mercifully, the IRS imposes no requirements for annual tax reporting.
Annual contributions to a SEP are discretionary; if you’re hurting for cash one year and need to cut back, you’re free to do so. Moreover, SEP contribution limits are relatively high: 25% of net income, up to $53,000 for 2015, which is ample for most people. (The amount is subject to annual cost-of-living adjustments for later years.) Also, another convenience is that you can set up and fund a SEP after the end of the tax year.
Can I temporarily cease contributions if I can’t afford it, but start up again later?
It depends on your employer. Some allow it; some don’t. However, most plans give you the latitude to stop contributing for a while. Check the rules with your HR department.
What are “hardship” withdrawals?
We advise against hardship withdrawals. Your best bet is to find another source of money for whatever need has arisen. You should treat your 401k as sacrosanct. That’s why it was troubling that during the Great Recession, many 401k savers cracked their accounts simply to make ends meet, further exacerbating the retirement crisis that faces America.
- Medical expenses incurred by you, your spouse, children, dependents, beneficiaries beyond what is covered by insurance;
- Payment of funeral or burial expenses for your spouse, children, dependents, parents, or beneficiaries;
- Purchase of primary residence;
- Payment of tuition for post-secondary education for you or your spouse, children, dependents or beneficiaries for the next semester or scholastic period;
- Prevention of eviction from your primary residence or foreclosure of the mortgage on your primary residence; and
- Payment or repair to your primary residence that qualifies for the casualty deduction of Internal Revenue Code Section 165.
Check with your HR department for further details.
What are the rules regarding loans from 401k plans?
We advise against taking out a loan against your 401k. But if you urgently need money, this option is available to you, depending upon your employer’s rules.
Companies are free to loans in 401k plans, but nothing compels them to do so. Your Summary Plan Description or HR department can make this clear for you. Typically, you must repay the loan within five years.
You’re allowed to borrow up to 50% of your vested account balance to a maximum of $50,000. Plans often establish a minimum amount and restrict the number of loans you can take at any one time. Repayment is usually n the form of installments automatically deducted from your paycheck.
If you leave your job, any unpaid portion of the loan will be calculated as income and be subject to taxation and, if you’re under the age 59 1/2, a penalty.
For further insights, consult the advisors at such tax or brokerage organizations as H&R Block, Liberty Tax, Charles Schwab, TD Ameritrade, or T. Rowe Price.
Are you making the right investment moves for your retirement, or are you blowing it by making all-too-common money mistakes? There are crucial steps that you should be taking now, to build wealth over the long haul. To determine whether you’ll have enough money in your later years, download our free report: Your Ultimate Retirement Guide.
John Persinos is editorial manager and investment analyst at Investing Daily. At the time of publication, the author held no positions in the stocks mentioned.