EBONY HAZELEGER: What you should know about your 401(k) plan

A 401(k) is a self-directed, qualified profit retirement plan that allows employees to contribute a portion of their wages on a tax-deferred basis. The name comes from a tax code-subsection 401(k). In a 401(k), you pay no taxes on any investment growth, interest, dividends or investment gains.

However, the IRS does come back around to take a cut once you start making withdrawals from the account during retirement. At that point, you’ll owe income taxes to Uncle Sam. Roth 401(k) contributions are made after-tax, but qualified withdrawals in retirement are free from federal income taxes. Both plans are the easiest to save for retirement because employers will automatically take money out of your paycheck and match some or all of what you contribute.

If you choose to participate in a 401(k), you are allowed to invest a percentage of your salary into your vehicle every month. The maximum amount that you can contribute to your 401(k) plan each year changes periodically, based on adjustments to the cost of living. For example, in 2017 and 2018, the maximum was $18,000 for anyone under 50. If you are 50 or older, you could contribute up to $24,000. If you reach age 50 or older before the end of the tax year, you are allowed to contribute an additional $6,000.

Contribution limits are indexed annually for inflation. Plus, money in your account accumulates tax deferred until you begin taking distributions in your retirement.

If you decide to withdraw funds at age 59½, you will pay income tax on any money you withdraw with an additional 10 percent penalty. Furthermore, your employer is required to withhold 20 percent of your payment to cover federal taxes. For example, a $10,000 early withdrawal would net you $8,000. If you need $10,000 in cash, you will actually have to withdraw $12,500 to make up for the withholding.

There are exceptions to the penalty based upon circumstances that the IRS considers a financial hardship such as suffering a total and permanent disability with medical expenses greater than 7.5 percent of your adjusted gross income. For example, if your income is $50,000, you can use your 401(k) for expenses higher than $3,750.

By law, you are required to “begin taking minimum distributions from your 401(k) no later than April 1 of the year after you reach age 70 ½ years of age.” The actual law also reads, “Distributions from a regular 401(k) are taxed as ordinary income and may be subject to a 10 percent federal income tax penalty if withdrawn before age 59 ½, except in special circumstance such as disability or death.”

Your 401(k) can be an effective vehicle for saving for your retirement if your employer offers matching fund contributions. The biggest drawback to a 401(k) is that your funds are subject to fees. And depending on how your organizer sets up your account, it can all be at risk. Still a 401(k) is considered to be a great secondary or additional retirement funding effort.

If you would like a free consultation about your current 401(k), give my office a call today.

Ebony Hazeleger is the owner and creator of Home Plan Advisors, which specializes in helping families become debt-free, maximize savings for college expenses and retirement, and establish emergency funds while minimizing risk and income taxes based on her smart money management system. For more information, call (866) 248-1871 or visit www.homeplanadvisors.com.