401(k) Contribution rules

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1 The 401(k) plan is a type of employer-sponsored retirement plan named after a section of the U.S. Internal Revenue Code. A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or "deferred", into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time. In the less common trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan's assets will be invested. All assets in 401(k) plans are tax deferred. Some companies match employee contributions to some extent, paying extra money into the employee's 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing contributions into the 401(k) plan or just contribute a fixed percentage of wages. These contributions may vest over several years as an inducement to the employee to stay with the employer. When an employee leaves a job, the 401(k) account generally stays active for the rest of his or her life, though the accounts must begin to be drawn out beginning the April 1st of the calendar year after the attainment of age 70½ (except that under SBJPA 1996, those still employed can defer). In 2004 some companies started charging a fee to ex-employees who maintained their 401(k) account with that company. Alternatively, when the employee leaves the company, the account can be rolled over into an IRA at an independent financial institution, or if the employee takes a new job at a company that also has a 401(k) or other eligible retirement plan, the employee can "roll over" the account into a new 401(k) account hosted by the new employer. 401(k) Contribution rules A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or

2 "deferred", into his or her 401(k) account. Some companies match employee contributions to some extent, paying extra money into the employee's 401(k) account as an incentive for the employee to save more money for retirement. Alternatively the employer may make profit sharing contributions into the 401(k) plan or just contribute a fixed percentage of wages. These contributions may vest over several years as an inducement to the employee to stay with the employer. Below are the limits an individual can contribute to their 401(k): Year Age 49 and Below Age 50 and Above $15,500 $20, $16,000 $21, (k) plan vesting rules- All of the money an employee contributes to a 401k plan is immediately vested in the plan. That means regardless of the employee's tenure, or time spent, with the company this money cannot be forfeited and must remain in their 401k account or moved via a 401k rollover. Of course the employee's contribution can also increase or decline in value, depending on how the money was ultimately invested. But the bottom line is that the employee's contribution is always theirs to keep along with any growth or decline in its value. In most 401k plans, it is up to the employer to decide when the employer match, if offered under the plan, is vested. Generally, this vesting would take place after five years or less of service, but only your program administrator can provide the exact rule. Since this is a very important rule for any 401k plan, the vesting rules should be spelled out in the plan's information materials and distributed to all participants. Investment rules

3 Since this is an employee sponsored plan, the company will hire an investment company to customize a selection of investment choices. The employee can select from a number of these investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above. Many companies' 401(k) plans also offer the option to purchase the company's stock. The employee can generally re-allocate money among these investment choices at any time. The employee is prohibited from selecting any other investment choices not offered by the investment company acting as custodian. Distribution rules Virtually all employers impose severe restrictions on withdrawals while a person remains in service with the company and is under age 59½. Any withdrawal that is permitted before age 59½ is subject to an excise tax equal to ten percent of the amount distributed, including withdrawals to pay expenses due to a hardship, except to the extent the distribution does not exceed the amount allowable as a deduction under Internal Revenue Code section 213 to the employee for amounts paid during the taxable year for medical care (determined without regard to whether the employee itemizes deductions for such taxable year). The tax code legally defines hardship as: Purchase of a primary residence (specifically excludes mortgage payments) To avoid foreclosure of, or eviction from, primary residence Payment of secondary education expenses incurred in the last 12 months for the employee, his/her spouse, or dependent(s) Medical expenses not covered by insurance for employee, their spouse, or dependent(s) which would be deductible on a federal tax return (i.e. non-essential cosmetic surgery would not be acceptable) Funeral expenses for the employee's deceased parent(s), spouse, child(ren), or dependent(s) (as of December 31, 2005) Home repairs due to a deductible casualty loss (as of December 31, 2005) In any event, any amounts are subject to normal taxation as ordinary income. Some employers may disallow one, several, or all of the previous hardship causes. Someone wishing to withdraw from such a 401(k) plan

4 would have to resign from their employer. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax deferred plan until the employee reaches 59 ½ years of age. Money that is withdrawn prior to 59 ½ typically incurs a 10% penalty tax unless a further exception applies. This penalty is of course on top of the "ordinary income" tax that has to be paid on such a withdrawal. The exceptions to the 10% penalty include: The employee's death The employee's total and permanent disability, A qualified domestic relations order Early Retirement (Substantially equal periodic payments) Deductible medical expenses. 401(k) loans- Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at pre-defined interest rates. The interest proceeds then become part of the 401(k) balance. The loan itself is not taxable income or subject to the 10% penalty as long as it is paid back in accordance with the terms of the Internal Revenue Code. These terms require, among other things, that the loan be for a term no longer than 5 years (except for the purchase of a primary residence), that a "reasonable" rate of interest be charged, and that substantially equal payments (with payments made at least every calendar quarter) be made over the life of the loan. Employers, of course, have the option to make their plan's loan provisions more restrictive. When an employee does not make payments in accordance with the plan or IRS regulations, the outstanding loan balance will be declared in "default". A defaulted loan, and possibly accrued interest on the loan balance, becomes a taxable distribution to the employee in the year of default with all the same tax penalties and implications of a withdrawal. Typical 401k Loan Rules As mentioned earlier, while the federal government might allow you to borrow money from your 401k plan, the plan administrator will have repayment rules that you need to be aware of before taking out a loan. Typical 401k loan rules might include: Length of Loan - typically the loan term would be five years (60 months) or less. In the case of a home loan, terms could be as long as 15 years. Loan Minimum - loan thresholds are usually $1,000. And quite frankly loans of lesser amounts shouldn't even be considered from a 401k account.

5 Loan Maximums - usually the lesser of 50% of the account balance or $50,000. Loan Fees plans can charge fees for loans including loan initiation fees and annual service charges. Repayment - repayment typically occurs evenly over 60 months, although as mentioned, 401k loans beyond 60 months are possible. Repayment usually is accomplished via direct payroll deduction. And like most loans, there are some pros and cons that come along with a 401k loan. Pros of 401k Loans Applying for a 401k loan is usually a very simple process. Most times you can arrange for a loan simply by calling the plan administrator. Any interest you pay on the loan goes back to your account. That is to say, you keep the interest you're required to pay on the loan. Interest rates are usually very competitive for 401k loans, even if you have poor credit. After all, you're borrowing your own money, so that limits non-payment risk. Cons of 401k Loans Perhaps the biggest drawback of a 401k loan is the fact some plans do not allow you to contribute to your 401k until the loan is completely repaid. So if your employer matches your 401k contributions, you're missing out on some "free" money until the loan is repaid. The interest rate / expense paid on a 401k loan is not tax deductible. The term of the loans - five years / 60 months - is relatively short when compared to alternatives such as personal loans. Forced Distributions- Account owners must begin making distributions from their accounts at least in the year after the year they turn 70 and one half. The amounts are based on life expectancy according to the relevant factors from the appropriate IRS tables. The only exception to minimum distribution are for people still working once they reach that age, and the exception only applies to the current plan they are participating in. Required minimum distributions apply to both pre-tax and after-tax Roth contributions. Only a Roth IRA is not subject to minimum distribution rules. Other than the exception for continuing to work after age 70 and a half differs from the rules for IRA minimum distributions. The same penalty applies to the failure to make the minimum distribution. The penalty is 50% of the amount that should have been distributed, one of the most severe penalties the IRS applies.