Certain Limits Apply To 401(K) Plans

Employees who want to save for their retirement often invest in what are known as 401(k) plans sponsored by their employers. These plans are great for saving taxes now and having money later, but they do come with certain restrictions.

For instance, the Internal Revenue Service sets an annual limit on how much of a person’s pay can be contributed, or “deferred,” each year to a 401(K). As an example, for 2010, the IRS has set an annual limit at $16,5000. In some cases, depending on the plan, workers who are age 50 or older can contribute an additional $5,500 in “catch-up” contributions.

These “deferments,” as they’re called, are also known as “pre-tax contributions.” Both terms mean the amount of money that an employee has deducted from a paycheck before income taxes to put into a 401(k) plan.

Each 401(k) plan has different rules regarding withdrawals from an employee’s account prior to age 59-1/2 years old. For instance, withdrawals or “loans” from the account can be taken for “hardship” purposes, which the IRS defines as “an immediate and heavy financial need.” The IRS currently defines six categories of “hardship.” These include:

• Medical expenses;

• Costs related to buying a home, except for mortgage payments;

• Educational expenses, including tuition, fees, and room and board expenses, for as much as 12 months of post-secondary education for the worker, or his or her spouse, children, or dependents;

• Payments to prevent eviction from the worker’s primary residence or foreclosure on his or her home;

• Payments for burial or funeral expenses for a worker’s deceased spouse, parent, children or dependents;

• Major home repair expenses.

In each of these cases, the IRS specifies details for how the relevant hardship is to be determined. It’s best to consult a financial advisor before proceeding with a hardship withdrawal.

What’s more, an employee who takes a hardship distribution from his or her 401(k) account isn’t allowed to make any contributions to the account for six months after the money is received.

Another factor to consider regarding early withdrawals is their effect on an employee’s taxes. The amount taken out is subject to a 20 percent mandatory withholding tax. Amounts taken from a 401(k) account before the minimum age also are subject to a 10% early withdrawal penalty, unless the employee qualifies for an exception such as those reasons listed above. In addition, the amount taken out of the account is added to the person’s total income for the year, making it subject to both federal and state income taxes. These are all good reasons not to touch a 401(k) account unless it’s absolutely necessary.

All employees should have access to what’s known as a 402(f) Special Tax Notice related to their 401(k) plans. This notice explains in detail the consequences in taxes if a employee takes a withdrawal, also known as a “distribution,” from his or her 401(k) account before the age limit of 59-1/2 years. The special tax notice includes information on: