Retirement Plan Rules: Separating Truth from Myth
Created by FindLaw's team
of attorney writers and editors.
There is a strong emphasis on investing in retirement plans early and often. And for good reason---doing so offers a number benefits for your long-term security. However, you should also be aware of the retirement plan rules and guidelines for maximizing your return that go hand-in-hand with investing in retirement plans.
Because these rules can be confusing to the layperson, certain myths have been perpetuated that are difficult to shake. Following are some common misperceptions about retirement plan rules to help reduce any confusion you may have.
410(k) retirement plans are employer-sponsored, with the employer often matching your monthly contribution up to a certain amount. The employer hires an independent third party financial advisor to make decisions about where to invest the money. Common myths and misperceptions about 401(k) plans include:
- You should name your estate as the beneficiary. Naming your estate as the beneficiary is likely to more drawbacks than benefits. If you want your money to go to the people of your choosing, make sure you name them as beneficiaries. Naming your estate means that whoever serves as trustee of the estate will make that decision, and your money may or may not end up with whom you wish.
- You will always pay a penalty if you withdraw from your 401(k) before retirement. The typical minimum age for cashing out or taking out a portion of your 401(k) is 59.5. Taking money out of the account before then is considered an early distribution and you'll likely have to pay a penalty fee and of course be taxed by the government (income tax). However, there are circumstances under which you may take money out of a 401(k) without being penalized (unfortunately, the income tax you can't do anything about)--for example to pay medical bills. Many 401(k) plans allow you to take out loans against the account for things like education or purchasing a home. You'll have to pay back the loan with interest, but it avoids reducing the amount in your 401(k) and allows it to grow at its projected rate. Check your 401(k) plan to see what types of early deductions it allows.
- You must contribute to your 401(k) by December 31 each year. You actually have until April 15 of each year (tax day) to contribute for the previous year. So if you get a bonus at the end or beginning of the calendar year, you can contribute a large chunk of it to your 401(k) to be calculated for the previous year.
- You must take distributions from your 401(k) each year after you turn 70.5 years of age. This is typically true, but if you are still working at the same company and still have a 401(k) there, you are not required to receive distributions.
- 401(k) plans are too expensive and cumbersome for small businesses to set up. While 401(k) plans can be intimidating for small business owners to contemplate, the reality is that based on cost versus benefit, setting up a 401(k) plan is advantageous for the company. While the experience obviously varies for each business, 401(k) plans can be relatively simple to administer and start-up and the benefit to the company in terms of employee satisfaction can be enormous.
- 401(k) plans are too risky--we should go back to the old system of company pension plans. This is a myth that's become outdated (fewer companies maintain "traditional" pension plans), but for a vast majority of people, untrue. Most of us will work for at least five employers in our lifetime and rather than cashing out your retirement after each employment stint (or worse, waiting for one of those companies to go bankrupt and be unable to pay your pension), it's probably a better idea to be able to rollover your retirement plan into your next employer's plan with a 401(k). 401(k) plans are meant to be cashed out after a long term, after you've invested in stock at a much lower price than they will be when you retire. Investing in "safe" (i.e., large, stable firms), diversified stock is more likely a better plan than the chance that you lose everything when a company you used to work for goes belly up and can't pay.
Individual Retirement Accounts (IRA)
IRAs and Roth IRAs are individual accounts which you create on your own. As with 401(k) plans, the amount you contribute is tax free during the life of the IRA (you will have to pay taxes at the beginning or end, depending on the type of IRA) and also reduces your taxable income by the amount of your contributions. The following are myths about IRAs that you can dismiss:
- Apart from a company possibly matching your contribution, there is no difference between an IRA and a 401(k) plan. The big difference is that IRAs can be self directed (meaning you can choose in what stocks to invest), while 401(k)s are limited to certain mutual funds. This means that 401(k)s may be more stable, but IRAs have the potential to earn much more or potentially lose more.
- You will always pay a penalty when withdrawing from your IRA before retirement. Like making an early withdrawal from your 401(k) plan, most such actions will result in penalties. However, there are more exemptions from early withdrawal penalties with IRAs that with 401(k) plans. Exemptions include permanent disability, purchase of first home, non-reimbursed medical bills, higher education, and paying medical insurance after being out of work for 12 weeks. Early withdrawals from any retirement plan should be considered a last resort, but if you've encountered the above situations, you may not have to pay a penalty. Check your IRA for a full list of exemptions.
- You should name your estate as beneficiary. See the 401(k) entry above.
- You may only take a specific amount from your IRA after age 70.5. While you are required to take a minimum distribution after this age, you can also choose to take more and are not bound by a specific amount. The requirement is just a minimum number.
- Roth IRAs don't ever require distributions to be paid out--meaning the accounts will continue to increase infinitum. While you don't have to take dividends if you choose not to, when you pass away your beneficiaries must take distributions. However, your surviving spouse may choose to continue deferring distributions if they so choose (though once they pass away, the beneficiaries must begin taking distributions ).
- I already have a retirement plan at work so I can't also have an IRA or Roth IRA. While the tax deductability of the IRA may be affected by the pre-tax status of a work retirement plan, you can have a work retirement plan and an IRA or Roth IRA.
Whatever retirement plan you choose there are regulations governing their growth, withdrawal, and payment of distributions. These are just a small sampling of the myths of retirement plan rules and you should read the rules of your retirement plan to maximize your profits and help assure your financial security in retirement.