How Does a Traditional 401(k) Work?

A traditional 401(k) plan is a pretax retirement plan. With this type of account, you invest in your retirement before you pay taxes. For example, if you save $10,000 in your 401(k) plan, you don’t pay taxes on that amount. This has the effect of actually lowering your taxable income, meaning you pay fewer taxes.

When you retire and begin using this money, you pay income tax then, probably at a lower tax rate than when you are working.

401(k) plans are payroll-deducted plans

In order to contribute to your plan, you will need to set up an account, and indicate your deferral percentage on your enrollment form or online. This tells the payroll software how much you want to invest before taxes are calculated. You cannot just send in a check to your account, since contributions are not possible after you’ve been paid.

When you invest in your 401(k), you will have the option to select from a variety of stock and bond mutual funds, in a variety of different categories. If you are unsure of how to invest, talk to a Slavic401k investment advisor representative at 800-356-3009 for help. You decide what the best investment option is based on things like your age and risk tolerance. It’s important to try to give yourself the best portfolio to meet your needs in retirement, and representatives are there to help. There is no additional fee for investment advice.

IRS Requirements

When you invest in a 401(k), there are certain requirements from the IRS, since it’s a pretax investment.The IRS puts a limit on how much you can contribute, and that number may change from year to year. In recent years, that number has been just under $20,000 per year, unless you are over the age of 50. In that case, you are allowed to contribute more.

Distribution Restrictions

There are also restrictions on when you can take money out of your account. Normal retirement is at the age of 67. However, you can begin taking money out at the age of 59 ½ - this is known as an in-service distribution. If you take a distribution before the age of 59 ½, you will be required to pay ordinary income tax as well as a 10% penalty.

While there are restrictions on taking money out of your account before retirement, there are a few ways you can access your money.

The first is a loan

You can borrow from your account, and pay it back to yourself at an interest rate of prime rate +1%. This lets you use your money however you want on the condition that you repay it. If you don’t repay it to your account, the IRS will treat it as a non-qualified distribution, and you will be required to pay ordinary income tax plus a 10% penalty.

The second way you can take your money out is through a hardship distribution

You can take your money out in order to avoid foreclosure, eviction, to pay catastrophic medical expenses, college tuition, or to buy your primary residence. These withdrawals are also subject to tax and penalty.