The 411 on 401 (k) Plans
Quote of the Week “Never let the future disturb you. You will meet it, if you have to, with the same weapons of reasons which today arm you against the present.” – Marcus Aurelius Technical Corner Stocks rose globally last week on optimism that Chinese and U.S. officials made progress in negotiations that laid the groundwork for a truce on additional tariffs. Positive comments on the Brexit front added to the optimism, leading international developed market stocks to record their biggest weekly rise in four months. Interest rates rose last week, along with the stock market. What we are seeing is that when the stock market rises, interest rates also tend to rise. The enthusiasm for the China deal has already faded this week. Part of the trade deal was for China to buy $50 billion of U.S. farm products. This morning it was reported that China said they couldn’t possibly buy that much from the U.S. farm belt. I personally think that the news of a “great deal” just around the corner is B.S. Time will tell, but I think the Chinese are waiting for the next U.S. election. Larry’s Thoughts During client review meetings, we hear a lot of questions from clients still worrying about their 401(k) plans. For many, their 401(k) is one of their most significant assets. The following is an excellent explanation of 401(k) plans. I believe this information is vital to understanding the rules and the advantages of contributing to a 401(k). Just a reminder, we help clients by using our software and Macro sources in the management of their 401(k). Just like any investment asset for retirement, it is essential to have the proper mutual fund allocation. 401(k) Plans Qualified cash or deferred arrangements (CODAs) permitted under Section 401(k) of the Internal Revenue Code, commonly referred to as “401(k) plans,” have become one of the most popular types of employer-sponsored retirement plans. How does a 401(k) plan work? With a 401(k) plan, you elect either to receive cash payments (wages) from your employer immediately, or defer receipt of a portion of that income to the plan. The amount you defer (called an “elective deferral” or “pre-tax contribution”) isn’t currently included in your income; it’s made with pre-tax dollars. Consequently, your federal taxable income (and federal income tax) that year is reduced. And the deferred portion (along with any investment earnings) isn’t taxed to you until you receive payments from the plan. Melissa earns $30,000 annually. She contributes $4,500 of her pay to her employer’s 401(k) plan on a pre-tax basis. As a result, Melissa’s taxable income is $25,500. She isn’t taxed on the deferred money ($4,500), or any investment earnings, until she receives a distribution from the plan. You may also be able to make Roth contributions to your 401(k) plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pre-tax contributions to a 401(k) plan, there’s no up-front tax benefit, but qualified distributions from a Roth 401(k) account are entirely free from federal income tax. When can I contribute? You can contribute to your employer’s 401(k) plan as soon as you’re eligible to participate under the terms of the plan. In general, a 401(k) plan can make you wait up to a year before you’re eligible to contribute. But many plans don’t have a waiting period at all, allowing you to contribute beginning with your first paycheck. Some 401(k) plans provide for automatic enrollment once you’ve satisfied the plan’s eligibility requirements. For example, the plan might provide that you’ll be automatically enrolled at a 3% pre-tax contribution rate (or some other percentage) unless you elect a different deferral percentage, or choose not to participate in the plan. This is sometimes called a “negative enrollment” because you haven’t affirmatively elected to participate — instead you must affirmatively act to change or stop contributions. If you’ve been automatically enrolled in your 401(k) plan, make sure to check that your assigned contribution rate and investments are appropriate for your circumstances. How much can I contribute? There’s an overall cap on your combined pre-tax and Roth 401(k) contributions. You can contribute up to $19,000 of your pay ($25,000 if you’re age 50 or older) to a 401(k) plan in 2019. If your plan allows Roth 401(k) contributions, you can split your contribution between pre-tax and Roth contributions any way you wish. For example, you can make $10,000 of Roth contributions and $9,000 of pre-tax 401(k) contributions. It’s up to you. But keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans — both pre-tax and Roth — can’t exceed $19,000 ($25,000 if you’re age 50 or older). It’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer. Can I also contribute to an IRA? Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $6,000 to an IRA in 2019, $7,000 if you’re age 50 or older (or, if less, 100% of your taxable compensation). But, depending on your salary level, your ability to take a tax deduction for your traditional IRA contributions may be limited if you participate in a 401(k) plan. What are the tax consequences? When you make pre-tax 401(k) contributions, you don’t pay current income taxes on those dollars (which generally means more take-home pay compared to an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax. In general, a distribution from your Roth 401(k) account is qualified only if it satisfies both of the following requirements: It’s made after the end of a five-year waiting period The payment
