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10 Important IRS 401k Facts to Safeguard Your Retirement Savings

Updated: Nov 9, 2023

One of the most important places to investigate 401k facts that affect your retirement? The IRS website. But it is difficult to stay awake for such tedious reading. So we’ve done the heavy lifting and have ten IRS 401k facts in a digestible form that won’t cause your eyelids to get heavy.

Why learn what the IRS has to say about your 401k retirement plan? Because they are really good at taxing it and have hit many Americans with the dreaded ten-percent early withdrawal penalty. Learn more in this quick read…

IRS Facts about 401ks

Fact #1: Elective deferrals and investment gains are not currently taxed and enjoy tax deferral until distribution. That means that the money you take from your paycheck and send to your 401k is protected from taxation. As long as it stays in the 401k until you reach a certain age (59 & ½ years old currently).

By the way, employers also save on federal taxes when they match a portion of employee 401k contributions. There are limits to the savings, of course, and are set by the Internal Revenue Service.

Fact #2: There are several types of 401k plans available to employers - traditional 401k plans, safe harbor 401k plans, and SIMPLE 401k plans. Different rules apply to each. Perhaps having one type would be the truly SIMPLE plan, but tax officials are complicated folks.

And this is America, where we tend to like a ton of choices.

Fact #3: A 401k plan cannot require, as a condition of participation, that an employee complete more than one year of service. That’s great to know when you are starting a new job. But depending on the job market, you can shop around for the best 401k options on top of pay and other benefits.

The reason to shop around is that many companies offer 401k plans on day one. Research shows that’s better than on day 364!

Fact #4: Auto-enrollment gets more workers into a retirement plan. Companies can put you in the 401k program without you signing up for it. You can opt out but the default choice is joining and it is done automatically.

It may not be ideal to think of someone deciding you should have your wages deducted by three percent each week. Even for your benefit. But investing is the responsible thing to do so you can see the reasoning here.

I’ve said it before but it’s worth repeating. Always look at the financial details whether you are starting a new job with new benefits, paying off a loan, investing money, etc.

Fact #5: The law, under IRC section 402(g), which sounds like a thrilling novel, limits the amount that a 401k participant can defer on a pre-tax basis each year. Most Americans aren’t saving enough for retirement so this restriction seems unnecessary.

However, the IRS’ thinking on this one could be that super-wealthy people could use it as a loophole. Or the government got bored and decided to toss an extra tax law on top of the plethora already on the books.

Fact #6: If the plan permits, the employer can make matching contributions for an employee who contributes elective deferrals to the 401k plan. This is what some call “free money.” In a simple example, if you deferred $100 per month into a 401k, your employer might match 50 cents for each dollar you put in. So they would add $50 to your 401k account each month in this example.

That’s a 50 percent return on your money - which is nice thrilling! Each employer is different. Some will match less than 50 percent, some may match more.

It is wise to take advantage of this so-called free money. Because getting a 50 percent return is a rare opportunity when you see it in that light. It’s a great way to jumpstart your retirement account if you are starting from zero also.

Fact #7: If the plan allows, the employer can make additional contributions (other than matching contributions) for participants, including participants who choose not to contribute elective deferrals to the 401k plan. This is a rule that the employees won’t have much control over. It relates to “key” employees and their 401k balances.

If those balances exceed 60% of the account balances of all employees then that triggers IRS requirements to level things out. The technical aspects of this are complex. Even the IRS admits this on their website. “The rules relating to the determination of whether a plan is top-heavy are complex.”

Employees can’t just go around asking management for a copy of their 401k reports then compare those to their own reports. That’s crazy and again, this is an aspect that is mostly out of the employee’s control with company retirement plans.

Fact #8: For 2022, no more than $305,000 of an employee’s compensation can be taken into account when figuring contributions. This rule would be helpful to high earners because it can be less limiting on how much you can add to your 401k each year.

Often earning “too much” comes with tax “punishments,” so this part of the tax code seems to be a benefit instead of an obstacle.

Fact #9: All employees must be fully vested in their elective deferrals (the money they take from a paycheck that goes into the 401k plan). A plan may require completion of a specific number of years of service for vesting in employer contributions.

For example, a plan may require that the employee complete 2 years of service for a 20% vested interest in employer contributions and additional years of service for increases in the vested percentage. It could also be three years for a 100% vested interest. It all depends on company policy.

*Vested definition: vested shares, pension plans, etc. can be legally kept by an employee who has worked the necessary number of years for a particular company.

Fact #10: Distribution rules govern when a plan may or must distribute benefits to participants. These rules are quite unruly. They are numerous and nuanced. So use this link to check out specific details that apply to you, your age, and situation.

The main point is that many people know that there are costs that come with withdrawing funds too early from a 401k. But not as many investors know the costs of withdrawing funds too late. There are deadlines for that and minimum amounts required to be withdrawn or distributed. The government wants you to get hold of your money in this case. Unusual for the IRS!

*Here are general rules on the mandated timeline. The required beginning date is April 1 of the first year after whichever comes later of the following years:

● Calendar year in which the participant reaches age 72 (70 ½ if the participant reaches age 70 ½ before January 1, 2020).

● Calendar year in which the participant retires.

Beyond those guidelines are a ton of “ifs” “ands” and “howevers” laid out by the official IRS site. So do your homework long before you retire and get professional guidance from your tax professional and financial advisor.

If you don’t have an advisor, please contact me for assistance that can prevent any 401k mistakes that cost you valuable chunks of your savings.

Hopefully, this was the one IRS 401k fact sheet that kept you from boredom that makes it too taxing to even research.

Investment advice offered through Private Advisor Group, LLC, a registered investment advisor.

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