So How Much Should You Invest In Your 401k
Okay. So, while investing is highly personal and financial goals should be personalized, you are here so we can teach you to be rich. We have some advice to get you started.
How much you should actually be investing each month depends on a system we call the Ladder of Personal Finance. It looks at three areas:
1. Your employers 401k match. Each month you should be contributing as much as you need to in order to get the most out of your companys 401k match. That means if your company offers a 5% match, you should be contributing AT LEAST 5% of your monthly income to your 401k each month.
Weve already discussed the importance of this dont throw away free money and the returns from that free money.
2. Whether youre in debt. Once youve committed yourself to contributing at least the employer match for your 401k, you need to make sure you dont have any debt. Remember, if you have employee matching, you are effectively earning a 100% return on every penny you invest in your 401k that is significantly more than the interest you would save by paying down your debt.
If you dont, great! If you do, thats okay. You can check out my system on eliminating debt fast to help you.
What Happens When You Cash Out A 401
This depends on your employment status, age, and possibly some other factors including whether you qualify for a hardship withdrawal.
The phrase cashing out implies that you want to take everything out of the plan, but it may be that you only need part of the money . Either way, taking cash out of a 401 is considered a withdrawal.
If youre still employed with the company that sponsors your 401 plan, you may not be able to withdraw funds unless you qualify for a hardship withdrawal or quit your job.
Hardship withdrawals may be available for various reasons including:
- Paying medical bills for you or your immediate family
- Up to $10,000 to make a down payment on your first home purchase
- Covering college tuition, and related expenses such as books for yourself or immediate family
- Funeral expenses
The decision of whether you qualify for a hardship withdrawal is up to the administrator of the plan. You can submit special cases for consideration, and they may ask you to explain why you cannot get the money somewhere else. If the administrator determines you do not qualify for a hardship withdrawal, then your request may be denied.
Some 401 plans may allow for in-service withdrawals while youre still employed, so you can check your plan documents to see if this is allowed.
If you are no longer employed, you can usually cash out a 401 plan. There may or may not be a penalty, depending on your age.
Series Of Substantially Equal Periodic Payments
This is another case where you can withdraw your 401 money without penalties even before turning 59 ½. Another name for this is 72.
If your plan allows it, you can agree to get the same monthly payment from your plan for the next five years or until you reach the age of 59 ½, whichever period is longer.
There are three methods to this:
- Required Minimum Distribution Method: this method uses the IRS RMD table to determine your Equal Payments based on your yearly account balance and your life expectancy factor.
- Fixed Amortization Method: your Equal Payment is calculated based on one of three life expectancy tables made by the IRS.
- Fixed Annutization Method: your Equal Payments are determined using the annuitization factor made by the IRS.
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Who Qualifies To Take A Cares Act 401k Withdrawal
To qualify for the tax penalty exemption:
- The account owner, their spouse, or dependent must have been diagnosed with COVID-19 by a CDC-approved test, or
- The account owner must have experienced adverse financial consequences as a result of COVID-19-related conditions. For example, adverse financial consequences might include a delayed start date for a job, a rescinded job offer, quarantine, lay off, job furlough, reduction in pay or hours, a reduction in self-employment income, the closing of a business, an inability to work due to lack of child care, or other factors.
The IRS explains those qualifications in more detail in Notice 2020-50, Guidance for Coronavirus-Related Distributions and Loans from Retirement Plans Under the CARES Act.
Withdrawing Money Early From Your 401
The method and process of withdrawing money from your 401 will depend on your employer, and which type of withdrawal you choose. As noted above, the decision to remove funds early from a retirement plan should not be made lightly, as it can come with financial penalties attached. However, should you wish to proceed, the process is as follows.
Step 1: Check with your human resources department to see if the option to withdraw funds early is available. Not every employer allows you to cash in a 401 before retirement. If they do, be sure to check the fine print contained in plan documents to determine what type of withdrawals are available, and which you are eligible for.
Step 2: Contact your 401 plan provider and request that they send you the information and paperwork needed to cash out your plan, which should be promptly completed. Select providers may be able to facilitate these requests online or via phone as well.
Step 3: Obtain any necessary signatures from plan administrators or HR representatives at your former employer affirming that you have filed the necessary paperwork, executed the option to cash in your 401 early, and are authorized to proceed with doing so. Note that depending on the size of the company, this may take some time, and you may need to follow up directly with corporate representatives or plan administrators at regular intervals.
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How Does A 401k Work
A 401k plan is a benefit commonly offered by employers to ensure employees have dedicated retirement funds. A set percentage the employee chooses is automatically taken out of each paycheck and invested in a 401k account. They are made up of investments that the employee can pick themselves.
Depending on the details of the plan, the money invested may be tax-free and matching contributions may be made by the employer. If either of those benefits are included in your 401k plan, financial experts recommend contributing the maximum amount each year, or as close to it as you can manage.
Exceptions To 401 Early Withdrawal Penalty:
- You stopped working for the employer sponsoring the plan after reaching age 55
- Your former spouse is taking a portion of your 401 under a court order following a divorce
- Your beneficiary is taking a withdrawal after your death
- You are disabled
- You are removing an excess contribution from the 401
- You are taking a series of equal payments that meet certain rules under the tax laws
- You are withdrawing money to pay unreimbursed medical expenses that exceed 10% of your adjusted gross income
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The Age 55 Exemption Applies Only To The Date Employment Endednot When You Begin Taking Distributions
This is important for those entering retirement early. For example, if you retired from Company ABC at age 50, you would still be subject to the penalty tax if you take distributions at age 55. Since your employment ended before the year in which you turned 55, youd have to wait until age 59 ½ for penalty-free withdrawals.
Roll Money Into An Ira
If you are not satisfied with the 401 investment options, you can rollover the money into an IRA since the latter has more investment options and offers greater control. You can reallocate your portfolio of investments to help you grow your investments further in years to come.
If you have a string of old 401s when you retire, you should consolidate them into an IRA for better management of your retirement savings. Also, you can reduce the administration fees of your retirement money, and even qualify for discounts on sales charges.
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Ira Rollover Bridge Loan
There is one final way to borrow from your 401k or IRA on a short-term basis. You can roll it over into a different IRA. You are allowed to do this once in a 12-month period. When you roll an account over, the money is not due into the new retirement account for 60 days. During that period, you can do whatever you want with the cash. However, if its not safely deposited in an IRA when time is up, the IRS will consider it an early distribution. You will be subject to penalties in the full amount. This is a risky move and is not generally recommended. However, if you want an interest-free bridge loan and are sure you can pay it back, its an option.
The 401 Withdrawal Rules For People Between 55 And 59
Most of the time, anyone who withdraws from their 401 before they reach 59 ½ will have to pay a 10% penalty as well as their regular income tax. However, you can withdraw your savings without a penalty at age 55 in some circumstances. You cannot be a current employee of the company that runs the 401, and you must have left that employer during or after the calendar year in which you turned 55. Many people call this the Rule of 55.
If youre between 55 and 59 ½ years old and you are considering a 401k withdrawal from an old employer, you should keep a few things in mind. For starters, doesnt matter why your employment stopped. Whether you quit, you were fired, or you were laid off, you can qualify for a penalty-free withdrawal. However, you need to meet the age requirement and your employment must end in the calendar year you turn 55 or later.
These rules for early 401 withdrawal only apply to assets in 401 plans maintained by former employers. The rules dont apply if youre still working for your employer. For example, an employee of Washington and Sons usually wont be able to make a penalty-free withdrawal before they turn 59 ½. However, the same employee can make a withdrawal from a former employers 401 account and avoid the penalty when he or she turns 55.
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Roll Over Your Assets To An Ira
For more retirement investment options and to maintain the tax-advantaged status of the account, roll your old 401 into an individual retirement account . You will have greater flexibility over access to your savings .1 Before-tax assets can roll over to a Traditional IRA while Roth assets can roll directly to a Roth IRA. Review the differences in investment options and fees between an IRA and your old and new employers 401 plans.
What’s So Great About 401 Accounts
A 401 is a popular type of employer-sponsored retirement plan that’s available to all employees 21 or older who have completed at least one year of service with the employer, usually defined as 1,000 work hours in a plan year. Some employers enable new employees to join right away, even if they haven’t met this criterion yet.
In 2021 you’re allowed to contribute up to $19,500 to a 401 or up to $26,000 if you’re 50 or older. These limits are much higher than what you find with IRAs, and they enable you to set aside a fairly large sum annually.
Most 401s are tax deferred, so your contributions reduce your taxable income each year. You must pay taxes on your distributions in retirement, but you may be in a lower tax bracket by then, in which case you would save money. Some employers also offer Roth 401s. You pay taxes on contributions to these accounts now, but you’ll get tax-free withdrawals in retirement.
Some employers also match a portion of their employees’ 401 contributions, which can make the task of saving for retirement a little easier. Each company has its own rules about matching, so consult with your HR department to learn how yours works.
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Making An Early Withdrawal
As pointed out previously, under commonplace circumstances, the regulation requires you to be at least 59 ½ years old to withdraw funds from your plan without any penalties and without having to terminate your employment.
If you want to make an early withdrawal of your assets, youll most likely have to make reimbursements for both taxes and tax penalties, depending on the circumstances. Distinctive situations are specified at the beginning of this article.
How Holtzmans Tax Team Can Help
Like other tax legislation, the CARES Act includes many intricacies that can complicate taking advantage of early 401k withdrawals. Holtzmans team of accounting and tax advisors can help you determine whether you qualify for a hardship withdrawal and identify other opportunities to minimize your taxes. Contact our Tax Services team to learn how this important piece of legislation can benefit you.
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Should You Use Your 401 To Buy A House
There are good reasons for not using your 401 to buy a house. Even if youre comfortable with the 10% early withdrawal penalty, you will still be incurring long-term consequences by reducing your savings. That, in turn, will damage your future growth potential.
Taking out $10,000 from a $20,000 401 account, for instance, leaves you with only $10,000 that will continue accruing interest. With a 7% annualized rate of return, that $10,000 could become $54,000 over 25 years compared to $108,000 had you not withdrawn $10,000.
Withdrawing from your 401 account is essentially taking out a loan against yourself. If you want to pay it back, you also need to pay interest, and the time spent paying it back is time that could have been spent on growth.
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Medical Expenses Or Insurance
If you incur unreimbursed medical expenses that are greater than 10% of your adjusted gross income in that year, you are able to pay for them out of an IRA without incurring a penalty.
For a 401k withdrawal, if your unreimbursed medical expenses exceed 7.5% of your adjusted gross income for the year then the penalty will likely be waived.
Three Consequences Of A 401 Early Withdrawal Or Cashing Out A 401
Taxes will be withheld. The IRS generally requires automatic withholding of 20% of a 401 early withdrawal for taxes. So if you withdraw $10,000 from your 401 at age 40, you may get only about $8,000. Keep in mind that you might get some of this back in the form of a tax refund at tax time if your withholding exceeds your actual tax liability.
The IRS will penalize you. If you withdraw money from your 401 before youre 59½, the IRS usually assesses a 10% penalty when you file your tax return. That could mean giving the government $1,000 of that $10,000 withdrawal. Between the taxes and penalty, your immediate take-home total could be as low as $7,000 from your original $10,000.
It may mean less money for your future. That may be especially true if the market is down when you make the early withdrawal. If you’re pulling funds out, it can severely impact your ability to participate in a rebound, and then your entire retirement plan is offset, says Adam Harding, a certified financial planner in Scottsdale, Arizona.
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What Is The Maximum 401k Contribution Amount
Starting in 2020 , you can contribute up to $19,500 each year to your 401k if you are under 50. If you are over the age of 50, you may be able to make catch-up contributions. This provision lets you invest up to an additional $6,500 in your 401k .
PRO TIP: You need to be behind in your 401k contributions to make catchup contributions.
When compared to a Roth IRA, where you can only contribute up to $6,000/year, this is an amazing opportunity especially since your pre-tax money is being compounded over time.