The amount that an employee may elect to defer to a 401(k) plan is limited. Therefore, your elective contributions may be limited based on the terms of your 401(k) plan. Refer to Publication 525, Taxable and Nontaxable Income, for more information about elective deferrals. Employers should refer to Publication 560, Retirement Plans for Small Business, for information about setting up and maintaining retirement plans for employees, including 401(k) plans.
Distributions from a 401(k) plan may qualify for optional lump–sum distribution treatment or rollover treatment as long as they meet the respective requirements. For more information, refer to Topic 412, Lump-Sum Distributions, Topic 413, Rollovers from Retirement Plans, and Topic 555, 10-Year Tax Option for Lump-Sum Distributions.
Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employees' elective deferrals only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions.
Distributions received before age 59 1/2 are subject to an early distribution penalty of 10% additional tax unless an exception applies. For more information about the treatment of retirement plan distributions, refer to Publication 575, Pension and Annuity Income.
Benefits from investing in a 401(k) Plan
• Your contributions, any employer contributions, and any earnings on your 401(k) account grow tax-deferred; which means they are not taxed until they are withdrawn. Consequently, you have more dollars working for you, and your account balance may grow more quickly.
• Your current gross income is reduced by the amount you contribute. Contributions are usually made pre-tax, which means you are not subject to Federal (or most state) income tax on your contributions to the plan until the money is withdrawn, typically at retirement. You may be in a lower tax bracket at that time; if so, you would pay less tax. This also means you have more money in your account working for you. Contributions are subject to Social Security and Medicare taxes.
• Automatic payroll deductions make saving for retirement easy. You’re less likely to miss money you never see. • You can control your own account. Unlike traditional pension plans, 401(k) plans often allow participants to choose how to invest their contributions. Participants can be as aggressive or as conservative as they wish in selecting investment options offered under the plan.
• The plan is “portable.” When you leave your current employer, you can have the option of rolling your 401(k) money over into an IRA (Individual Retirement Account) or a new employer’s plan or withdrawing the money. Keep in mind, however, that withdrawing money before age 591/2 can mean you will pay taxes on the withdrawal and, generally, an early withdrawal penalty of 10 percent if the money is not rolled over or directly transferred to an IRA or another qualified retirement plan on a tax-deferred basis.
• You can invest in professionally managed funds at no minimums. Retail financial service providers may impose minimum investment requirements. With a 401(k) you can get started investing a little at a time.
• You may be able to borrow from your account. Many plans have loan features that let you withdraw money (without taxes or penalties) as a “loan to yourself.” You may be able to pay the loan back automatically through payroll deduction, and the loan interest goes into your own account, too.
• Your employer may contribute “matching” funds on a portion of your savings. If so, you reap an instant benefit from contributing to your plan. For example, if your employer contributes 50 percent of the amount you contribute, you would receive an additional $50 added to your account for every $100 you contribute, up to the plan limits.
