The need for well thought-out retirement planning has been increasing in recent years by the fact that people are living longer, and are still hoping to retire at the age of 60. This significantly increases the portion of their life during which they’re classified as “retired”. For this reason, the option of having a 401(k) is much sought-after by the American workforce.
Definition of a 401(k)
A 401(k) is a specific savings account used for the purposes of retirement planning. The term “401(k)” is actually the name for a subsection of the Internal Revenue Code. The way that it works is employers will automatically deduct a small amount of the qualified employee’s pay, and deposit that sum into the 401(k) account. The employer who wishes to aid in their employee’s retirement planning efforts can also make contributions to the 401(k), usually matching the contributions made by the employee. This amount is then saved until the employee retires, and is used to support them in their post-employment years.
Withdrawing 401(k) Funds Pre-Retirement
When it comes to retirement planning, it is considered financially prudent to accrue an amount that will see an individual through their retirement years. For this reason, there are restrictions put on when a person is allowed to withdraw funds from their 401(k). If a person withdraws funds prior to turning 59 and a half, they will have to pay an excise tax, amounting to ten percent. If the individual has reached the age of 55, and is permanently disabled, they may withdraw from their 401(k) without incurring the excise tax.
Taking Out a Loan From a 401(k) Plan
If an individual has a large sum of money set aside for the purposes of retirement planning, it may seem very tempting to borrow from this account from time to time, and many 401(k) plans allow individuals to do exactly this. The allure may be even greater, given that the loan amount is not subject to the regular excise tax incurred when funds are withdrawn prior to retirement. The repayment terms of the loan are: that duration of the borrowing must be no more than 5 years, is subject to interest, and is also subject to tax upon repayment. For this reason, many advisors in the retirement planning industry will advise against taking such a loan.
Retirement Planning Similar to a Standard 401(k)
While a standard 401(k) may be adequate in terms of retirement planning for employees of large businesses or corporations, sole-proprietorships and entrepreneurs have found these plans unable to meet their needs, given that there is nobody to match their contributions. A Solo-401(k) allows for an increased contribution limit of up to 25% (as opposed to 15% in a standard 401(k)). This sort of retirement planning can be done through a Self-Directed 401(k), which in turn allows for the individual to invest their funds in things like stock markets, private companies, or even real estate.
Provided that an individual contributes more than their automatic payroll deductions, which don’t usually come near the allowable 15%, and can be fiscally-responsible when it comes to taking a loan, a 401(k) can be a perfectly sufficient method of retirement planning.