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401(k) Basics

401(k) Basics

         

          A 401(k) represents a way to reduce your taxable income since contributions come out of your pay before taxes are withheld; many plans include a matching contribution from your employer; and the money you save benefits from tax-deferred growth, which lets your money compound more quickly than it would if it were taxed yearly.

          Contributing part of your salary to a 401(k) gives you three compelling benefits:

          - You receive an immediate tax break, because contributions come out of your paycheck before taxes are withheld.

          - The possibility of a matching contribution from your employer -- most commonly 50 cents on the dollar for the first 6% you save.

          - You recieve tax-deferred growth -- meaning you don't pay taxes each year on capital gains, dividends, and other distributions.

          You'll be able to contribute more tax-free money to your 401(k) next year, as the IRS recently announced that the contribution limit for employees participating in pension plans -- including 401(k)s, 403(b)s, most 457 plans and the federal government's Thrift Savings Plan will be $17,000 for tax year 2012.

          Keep in mind, however, that while federal law sets the guidelines for what's permissible in 401(k) plans, your employer may set tighter restrictions.

          For all its tax advantages, the 401(k) is not a penalty-free ride. Pull out money from your account before age 59-1/2, and with few exceptions, you'll owe income taxes on the amount withdrawn plus an additional 10% penalty.

          When faced with a sudden cash crunch, it can be tempting to tap your 401(k). But if you're under 59-1/2, keep in mind that an early withdrawal from your 401(k) will cost you dearly. You'll miss the compounded earnings you'd otherwise receive, you'll likely get stuck with early withdrawal penalties, and you'll certainly have to pay income tax on the amount withdrawn to Uncle Sam.

          When you change jobs, you'll often have three choices: leave your 401(k) money where it is, roll it into an IRA or another 401(k), or cash out.

Find out what rules, if any, the employer imposes on when and how you must start taking distributions. If there are none, you may leave the money untouched until you're 70-1/2. That's the age when Uncle Sam insists all retirees begin withdrawing money from traditional IRAs and 401(k)s.

 

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