Understanding 401k Plans

Answer 1

401k plans are employer-sponsored, tax-deferred employee retirement plans. In general, both the employer and employees make pre-tax contributions to individual employee retirement accounts. For any specific amount of pre-tax income that an employee contributes, the employer will make a matching contribution to the employee's account in the same amount. The employer is also responsible for retaining a plan administrator to manage all account assets including handling any account withdrawals. Money contributed into 401k plans often is invested in various financial securities to grow plan assets from investment returns. Taxes on any capital gains and interest income generated by plan investments are also deferred until the time of withdrawals. A separate investment advisor, usually a mutual fund company, is hired to manage plan investments, and employees may choose from a range of investment selections offered by the investment advisor.

Qualified Withdrawals

401k plans are for retirement purposes with favorite tax provisions and thus, there are strict rules governing plan withdrawals and limiting any non-retirement-related early withdrawals. Employees are free to withdraw money from their 401k accounts once they reach the retirement age of 59 and half. Under certain special circumstances, employees may make qualified early withdrawals without penalties. For example, employees may use their 401k money to cover tax deductible medical expense, supplement their income if they have become permanently disabled, or satisfy a domestic court order that requires payments be made from a 401k account. Employees may also make qualified early 401k withdrawals if they are 55 or older, but no longer working because they have been permanently laid off and subsequently chose to retire early.

Hardship Withdrawals

401k rules also allow certain early withdrawals under the hardship conditions but with a 10 percent excess tax penalty on the amount withdrawn. Hardship conditions are defined as immediate and severe financial need and the lack of other ways to meet the need. Additionally, fund uses from the withdrawals must meet the prescribed requirements. Funds withdrawn under hardship withdrawals can be used to cover non-tax-deductible medical expense, make payments to buy principal residence or prevent eviction or home foreclosure, and pay for costs related to home repair, higher education, or a family member's funeral costs.