401k or Defined Contribution Plan Information You Must Know

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A 401k is an employer sponsored defined contribution plan. As part of your employee benefits, most of you may have participated in your employer’s 401k plan.

The plan allows a worker to save for retirement up to $16,500 for 2009 and 2010. Anyone who is 50 years and older is allowed to put additional savings up to $5,500 as a "catch up" contribution. Current income taxes are deferred on the saved money and earnings until withdrawal.

When participating in the plan, an employee determines the amount or percentage of salary he or she wants to contribute into the plan. The employer may match the employee's contribution, i.e., 50 cent to a $1 of his or her contribution up to a set maximum amount or percent of the employee's contribution.

When your employment is terminated, you are faced with the question on what to do with your 401k and the consequences of your decision. It is important that you understand your options and weigh in course of action you take.

What are your options?

  • You can leave your account with your former employer. Typically, you can do that if you have $5,000 in your account.

  • Open an IRA (Individual Retirement Account) with a reputable financial institution and roll over your 401k account to avoid early withdrawal penalty. Weigh in the associated fees, available investment funds or investment vehicles vs. leaving your account with your former employer.

  • Direct Rollover to your new employer’s plan. Do a comparison between leaving your account with your former employer and rolling it over to your new employer’s plan.

  • Withdraw your contribution. I hope this is not an option you are forced to take. When you contribute to a 401k, there are restrictions that the money must be kept in the plan until you reach 59 ½ years of age.
  • If you withdraw your money prior to this age, you will typically incur a 10% penalty tax plus the 20% withholding on the pre-tax contributions and earnings portion of the eligible rollover distribution, which the plan is obligated to pay the IRS to cover federal income taxes.

    Some of the exceptions to the 10% penalty tax are employee’s total and permanent disability, employee’s death, or qualified domestic relations order, and in debt for medical expenses exceeding 7.5% of your adjusted gross income.

    Weigh all the pros and cons of the different options above and determine which option will have the least negative financial impact for you in the long run.

    For more information on what to do with your 401k, check out CNNMoney.com Better Alternative to 401k.

    401k Loans

    If you have a loan, make sure you check with your employer your options. Ideally, you will be able to continue making your loan payments in order to avoid penalty tax.

    Any unpaid loan will be distributed to you and will be subject to ordinary income tax plus 10% penalty tax if you are not 59½ year old.

    Your employer should provide you with information regarding your loan once you leave the company.

    Make sure you have received and understand all the information provided by your employer and act accordingly.

    For additional information on defined contribution plan or 401k can be found at the Internal Revenue Services, go to irs.gov

    401k, Defined Contribution Plan
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