Understanding 401K Rules

There are a number of 401k rules that must be followed when dealing with your 401k plan. 401k rules apply to contribution limits, loans, rollovers, withdrawals, and more. So, it's important that they are handled properly.

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401k Rules

A 401k or 401(k) plan is a plan that allows U.S. workers to save for their retirement. One of the primary benefits of a 401k retirement plan is that investments into the plan are tax deferred. That means the earnings you contribute to a 401k plan are not taxed until they are later withdrawn. You can’t simply invest and withdraw from a 401k at will. Instead, you must follow the 401k rules set forth for these plans.

Contributing to Your 401k

There is a federally-mandated maximum contribution limit for 401k plans. In 2010, the 401k limit remains $16,500. This is the maximum amount you can contribute to your 401k plan if you are under age 50. If you turn 50 during the calendar year, you can make a catch-up contribution of $5,000.

You can only contribute to your 401k through payroll deduction. You’re not allowed to invest in your 401k any other way.

Employers are allowed to contribute to your 401k plan on your behalf. Many employers have a matching program where they contribute a certain amount that is based on your contribution. For example, your employer may match your contributions by 50%. So, in that case, if you contribute $500 a month, your employer would contribute $250.

Although income contributed to your 401k is not federally taxed until it is withdrawn, it is subject to several other taxes including social security, Medicare, and federal unemployment taxes.

401k Withdrawal Rules

To withdraw from your 401k without receiving a penalty, you must wait until you are 59 1/2, with some exceptions. If you retire or leave your company before age 59 1/2 but after age 55, if you become disabled, or if you meet your employer’s 401k hardship qualifications you are able to make a 401k withdraw without receiving a penalty. Withdrawing from your 401k in other circumstances results in a 10% penalty. You’ll also face income taxes on the amount you’ve withdrawn.

If you’re eligible for 401k withdrawal, you can take 401k lump sum distributions minus a 20% IRS mandatory withholding amount. You can also withdraw the money to place it into another retirement account.

After you reach 70 1/2 or you retire, you must begin taking the required minimum distribution (RMD) from your 401k plan. If you don’t take out the RMD, you face a penalty from the IRS.

401k Rules on Loans

Some 401k plans allow you to borrow money from them. Those plans that do allow 401k loans, limit the loans to 50% of the vested balance or $50,000. Generally, 401k loans have to be repaid within 5 years. You may take more time to pay your loan if it was used to purchase the home you currently reside in.

You can only have $50,000 in outstanding 401k loans at any given time. So, if you need to borrow again after taking out a first loan, the maximum loan amount is reduced by your current loan. Additionally, you must take out the second loan within 1 year of the previous loan.

If you leave your company, regardless of the reason, you will have to repay the outstanding 401k loan balance in full within 60 days. If you don’t repay, the remaining balance will be subject to the 10% early withdrawal penalty. Similar 401k rules apply if you default on your loan payments.

401k Rollover Rules

When you leave your job, you’re able to do what’s called a 401k rollover into your new employer’s 401k plan, or into another retirement account like an IRA account. You typically have a certain amount of time, like 60 days, to deposit your 401k funds into a new account before you face an early withdrawal penalty. If you don’t have your 401k directly rolled over into your new account, and instead receive the withdrawal yourself, you will have 20% of the withdrawal withheld. Even though part of your withdrawal is withheld, you still have to deposit the full amount of previous 401k investment into a new account. That means you must come up with that 20% from another place.

More Information on the 401k Rules

If you have questions about your 401k plan and the rules you’re required to follow, talk with your 401k plan administrator. Your manager or human resources contact may be able to help you locate your plan’s administrator.