Saving for retirement looks different for everyone, but a popular plan that many people utilize is a traditional 401(k). As a pre-tax retirement savings account, traditional 401(k) plans allow you to invest in your retirement before paying taxes.
For example, if you save $10,000 in your 401(k) plan, you don’t pay taxes on that amount, which lowers your taxable income each year. The money is only taxed when you withdraw the funds in retirement, which may be a lower tax rate than you had while employed.
Setting Up a Traditional 401(k)
Because 401(k) contributions are deducted from your payroll, in order to participate in a plan, you will first need to determine how much you want to contribute when you enroll. By choosing a set percentage, that amount will be deducted from your paycheck each pay period before your income is taxed.
When contributing to a traditional 401(k) plan, you will have the option to select from a variety of investments, including stocks and bonds, mutual funds, and more.
As a pre-tax retirement savings plan, the Internal Revenue Service (IRS) has specific requirements that traditional 401(k) participants must follow, such as contribution limits and distribution schedules.
A contribution limit is determined by the IRS on an annual basis, which restricts the amount of money that participants can deposit into a traditional 401(k) every year. You can find this year’s limits here.
There are some leniencies for participants over the age of 50 who can enroll in catch-up contributions. The limit can change annually, but you can view this year’s total through the IRS.
Other requirements may apply, so it’s best to talk to a financial advisor about the details of your plan before you start contributing or withdrawing funds.
Traditional 401(k) participants should also be aware of distribution restrictions. Depending on your company’s plan, you may elect to take non-periodic (lump-sum) or periodic (annuity or installment) distributions. The IRS defines the terms of distributions and required distributions here.
Participants can begin withdrawing funds at the age of 59½ for an in-service distribution. If you take distribution before the age of 59½, you will be required to pay ordinary income tax as well as an additional 10% penalty fee.
Borrowing from a Traditional 401(k)
While there are restrictions on withdrawing funds from your retirement account, there are also a few ways you can access your money if needed.
The first option is to take out a loan. You can borrow from your account and pay it back to yourself at a prime interest rate of +1%. This allows you to use your money on the condition that you repay it within a specified timeframe. If you don’t repay it back to the account, the IRS will treat it as a non-qualified distribution, and you will be required to pay ordinary income tax plus a 10% penalty fee.
The second option is to take your money out through a hardship distribution. This allows you to take your money out in order to avoid financial hardship, such as a home foreclosure, eviction, college tuition, or catastrophic medical expenses. These withdrawals are subject to tax and penalty but can help you in a time of need.
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