Why 401(k)s are not bank accounts
The 401(k) is a very popular retirement plan. A 401(k) (or 403(b) if you work in education) is offered by your employer. Here’s how it works:
1. A percentage of your income is deposited into your 401(k). You do not pay taxes on this amount until you withdraw this money from the 401(k). Remember, you don’t have to contribute to your 401(k) – it is optional, but it’s a wise idea. The earlier you start, the more money you’ll have by the time you retire. Those just out of college at age 22 should begin contributing to their 401(k) plans if their employer offers one. The money in a 401(k) will be invested and hopefully diversified into an array of various investments including, stocks, your company’s stock (if applicable), bonds, mutual funds, exchange traded funds (ETFs) and money market funds. Many times you can choose what you want to invest in for your 401(k).
2. Your employer may choose to match whatever amount of money you deposit into the 401(k). Now there are limits as to how much money you can put into your 401(k). For the year 2009, you can deposit a maximum of $16,500 (or $22,000 if you are over age 50) into your 401(k). Let’s say your employer, as mentioned above, will match whatever amount of money you deposit into the 401(k). So if you deposit 3% of your income, for example, your employer will also deposit 3% of your income into your 401(k). But if you deposit 5% of your income into the 401(k), for example, then your employer will also deposit 5% of your income into the 401(k). In other words, whatever amount of money your employer matches is free money to you, so in order to receive the most “free money”, it is best to contribute to the maximum amount of money your employer is willing to match. Usually, employers will match 6% of your income. But if you contribute to the maximum or close to the maximum, and that puts a huge strain on your finances, then contribute less. Only increase your contributions if you can afford to do so!
Now sometimes your employer won’t contribute anything to your 401(k). In this case, there is no “free money” and you should contribute whatever amount you feel comfortable with and whatever amount you can afford.
Withdrawing Funds from the 401(k)
As mentioned in the beginning of this article, the money you direct to your 401(k) is money that has not been taxed. The rule of thumb is to withdraw money from a 401(k) after age 59 and a half, in order to avoid a 10% penalty. If you withdraw money out of the 401(k) before age 59.5, you will owe a 10% penalty on the amount withdrawn. Regardless of what age you withdraw money out of the 401(k) (whether before or after age 59.5), you will owe ordinary income taxes on that amount, since again, the money sitting in your 401(k) plan has never been taxed before. The thinking is that when you withdraw money from the 401(k) later in life when you are retired or near retirement, you’ll probably be in a lower tax bracket, which will result in fewer taxes. It is a bad idea to withdraw money from your 401(k) before age 59.5 (many people need to withdraw this money to pay off credit card debt and pay off a mortgage) because of that 10% penalty. However, if you withdraw money from a 401(k) to pay for education costs, you will not (in most cases) have to pay the 10% penalty – but you will have to pay ordinary income taxes on that amount.
Here is another reason why you should not withdraw money from a 401(k) early: The money in a 401(k) should not be thought of as a bank account (hence the title of this article). The money in your 401(k) is retirement money and is money that you’ll need when you are no longer working. Also, should you ever claim bankruptcy, money in 401(k) plans cannot, in most cases, be taken away from you. It’s always a good idea to leave the money in a 401(k) plan alone (unless it’s a real emergency).