401k Retirement Plans

Many employers sponsor a retirement plan called the 401k plan.  The 401k retirement plan lets individuals save money for their retirement without paying income tax on the 401k contribution amounts, or the interest and earnings the account generates until the money is withdrawn. 

401k Tax Implications

To participate in a 401k retirement plan, an employee agrees to have an amount of his or her income automatically deposited into the 401k account each pay period.  Most plans are considered participant-directed plans, as they allow the employee to make selections about where their investments go- although most are mutual fund based, and mix up the investment into stocks, money market investments and bonds.

The money in a 401k plan is tax deferred- including both the 401k contribution and the earnings the money has generated.  Participants in 401k retirement plans can decide to put some or all of their contributions into a Roth account (often called a Roth 401k) .  When you take a 401k distribution from the Roth account, the money is tax free; when you make a Roth contribution, they are made after the income tax has been withheld from the income.

401k Withdrawals

Money from a 401k plan is not supposed to be withdrawn before the participant is the age of 59.5 years.  In some cases, however, an employer may allow a person under the age of 59.5 to make 401k hardship withdrawals in order to pay expenses that are the result of a hardship.  Some hardships that could qualify include:

• Buying a primary residence
• Avoiding foreclosure or eviction from a primary residence
• College/secondary education payments incurred within 12 months for 401k plan participant, his or her spouse or their dependent(s)
• Medical care that is not covered by the health insurance
• Funeral expenses of qualified family members
• Home repairs required due to a qualified casualty loss

When a 401k hardship withdrawal is taken before the age of 59.5,  that money is taxed as ordinary income.  Employers decide whether or not to grant a withdrawal.  If you are denied permission to make a 401k withdrawal, you would actually have to leave the job in order to make a 401k withdrawal.

A 401k early withdrawal will be charged 10% penalty tax, unless the employee has died, experienced a total and permanent disability, or has left the job at or after the age of 55.

401k Loans

Many 401k retirement plans allow participants to take loans from the 401k balance.  The loans are repaid using after-tax money, and is repaid at a specified interest rate.  Interest paid on 401k loans is paid back to the 401k balance; so it's very much like "paying yourself back at interest". 

401k loans are not considered taxable income, and do not have to pay the 10% penalty tax provided the loan is repaid according to the Internal Revenue Code section 72(p).  Requirements under the code for 401k loan repayment includes that the loan must be paid back within 5 years or less, that the loan repayments include a reasonable interest rate,  and that equal payments are made at a minimum of once per quarter.  Employers may also place restrictions and provisions on 401k loans and the repayment requirements.