In my previous post, I touched on the importance of saving to retirement plans. Remember - compounding interest is your best friend. The follow up post touched on the vesting schedule and portability of retirement plans. Before I leave the topic of 401(k) plans, I want to briefly touch on contribution limits and withdrawing funds.
You may contribute up to $17,000 for 2012. If you are age 50 or older, you can take advantage of the “catch-up” provision. This provision will allow you to contribute an additional $5,500 to your 401(k) plan for a total of $22,500.
Contributing to your retirement plan is extremely important. Besides the compounding interest phenomena as discussed in part 1, you will also reduce your taxable income thus causing your tax liability to be lower. How?
- Quick example:
- In the 2011 tax year, a single person earning $50,000 pays $8,625 in federal taxes. Conversely, by contributing 10% of pre-tax earnings to a 401(k) plan will reduce the participant’s taxable income by $5,000 making their taxable income $45,000. As a result of savings towards retirement, the participant saves $1,250 in taxes.
If you hit rock bottom, and I do mean the bottom, then you could do one of two things - take a hardship withdrawal or a loan from your retirement account. Of course Uncle Sam will receive his fair share of taxes and in some cases you may incur an additional percentage penalty before it touches your hands. This penalty is put in place to remind you that this money is to be saved for your retirement.
There are a ton of nuances involved with taking such distributions, but I will give you a high level overview.
The following items are considered by the IRS as acceptable reasons for a hardship withdrawal:
- Unreimbursed medical expenses for you, your spouse, or dependents
- Purchase of principal residence
- Certain expenses for the repair of damage to the employee's principal residence
- Payment of college tuition and related educational costs for you, your spouse, dependents, or children who are no longer dependents
- Payments necessary to prevent eviction of you from your home, or foreclosure on the mortgage of your principal residence
- Funeral expenses
Check out the IRS website for more information: Hardship Distributions
There are a lot of specifics that are involved if you should take a loan from your 401(k) plan (check with your HR department). Just know this – you will be taxed twice, double taxation – that should be a good enough reason for you not to take a loan.
- You have to pay income tax on the amount you are borrowing which could range from 15% to 25% of the amount distributed.
- The money used to pay back the loan has already been taxed… You are using after tax money (usually from your paycheck) to pay back a loan you have already been taxed on!
Saving now is very important. Delaying instant gratification will pay off, literally! You may not see it now, but years down the line you will have accumulated a large nest egg.
Catch up with my previous two posts. Click the links below: