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Rumors were swirling that lawmakers were going to change the rules surrounding 401(k) plan contributions as part of their tax overhaul … but it sounds like the idea has been completely scrapped for now.
That makes this a good time to talk about these plans in greater detail, along with other types of retirement accounts and how they fit into your overall financial picture.
It’s a very large topic so I want to cover it over the next several days.
Today, we’ll start with the basics on 401(k) plans — including my thoughts on the newer Roth variety.
For most regular working Americans, 401(k) plans represent THE way to save for retirement.
In fact, there are about 500,000 different employer-sponsored 401(k) plans in the United States right now, with more than 50 million active participants.
These accounts have been permitted by section 401(k) of the Internal Revenue Code since 1980, the result of legislation passed by Congress in 1978.
The idea is pretty simple: you can take out some of your money and put it into a special retirement account. In doing so, you don’t owe income taxes on it until you withdraw the money.
If you wait to take the money until you’re at least 59 1/2, you just pay taxes on what you withdraw (including investment gains).
If you take money out sooner, you owe taxes plus an additional 10% early withdrawal penalty.
Actually, that’s a bit oversimplified.
For example, it may be possible to take a certain amount of money out penalty free for certain financial hardships. Many plans have this feature but not all. (More details from the IRS here.)
Likewise, there is a little-known provision known as the “Rule of 55” that allows anyone 55 or older to avoid the early withdrawal penalty as long as they separated service in the year they turned that age or at any point thereafter.
Either way, since many people drop into lower tax brackets during their retirement years, the tax deferral is a nice feature. And as a side benefit, there’s more money in the account to invest over all the years in between.
Contribution matches are an additional benefit offered by many employers, many of whom are much happier to kick in a little money rather than have the much larger obligations they had with defined benefit pension plans.
If you currently have access to a 401(k) plan with some type of employer match, my recommendation is always contributing enough to get the maximum amount of “free” money.
The absolute maximum that any regular employee can contribute to a 401(k) is $18,000 for 2017 and $18,500 in 2018.
However, if you’re age 50 or older you can also take advantage of an additional “catch-up” contribution of $6,000.
Now, how much you should contribute depends on a number of factors.
Your personal budget is obviously one.
Your tax picture is another.
Plus, you need to consider your access to other types of accounts and how they fit into a …read more
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