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401(k) Rules You Need to Know

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Saving for retirement is a constant struggle. In your own personal fight to retire rich, a 401(k) can be one of your most potent weapons. But knowing the 401(k) rules is essential if you want to take maximum advantage of the opportunity without running afoul of the IRS.

Fortunately, learning the rules and regulations that govern your account isn't too hard. Below, you'll find the most important 401(k) rules to keep in mind as you plan your retirement strategy.

Maxing out your 401(k)
The key advantage that 401(k)s give workers is the extremely large amount that you're allowed to contribute each year. For 2012, the rules allow you to put as much as $17,000 into your account, with those age 50 or over entitled to an even higher limit of $22,500. When you compare those figures to the much lower allowed contributions of $5,000 to $6,000 for IRAs, you can easily see how much more valuable 401(k)s can be to shelter income from tax. Moreover, unlike IRAs, there are no income limits that restrict whether you can deduct contributions to your account.

With the end of the year approaching, you're running out of time to max out your 401(k). But it's not too late. In most cases, changing the amount you put into your account is as easy as talking to your HR department.

Make your match
The other substantial benefit that 401(k)s offer many workers is the ability to earn matching contributions from employers. A large number of companies offer employer matching plans for the money you deposit, with a typical match adding as much as 3% to 4% of your salary if you contribute at least twice that amount from your own pocket.

One thing to remember is that the rules don't require employers to keep doing a 401(k) match even if they've done so in the past. During the financial crisis, Ford (NYSE: F  ) , Paychex (Nasdaq: PAYX  ) , and Regions Financial (NYSE: RF  ) were among dozens of companies that temporarily suspended matching. Later, all three went back to implementing matching programs, but the episode serves as an important reminder that you're not entitled to a match.

Be smart about loans
401(k)s are great vehicles for retirement saving, but they do lock up your money. One way that many workers have gotten much-needed access to their 401(k) money before retiring is to take out loans.

Unfortunately, the rules governing 401(k) loans have some traps for the unwary. Ordinarily, 401(k) loan provisions are extremely favorable, offering reasonable interest rates, repayment periods that typically run up to five years, and minimal administrative costs. A big problem comes in, though, if you leave your job while you have a loan outstanding -- whether your departure is voluntary or not.

Specifically, once you leave your job, you must repay your entire 401(k) loan within 60 days, regardless of the original timetable for making loan payments. If you don't, then the outstanding balance is treated as a premature distribution, and you'll owe taxes on that amount as well as potential penalties.

Given high unemployment rates in recent years, defaults on 401(k) loans have soared. According to one study, the rate of default has gone up from less than 10% before the recession to more than 17% recently.

Be careful with employer stock
401(k) plans often offer you the chance to buy shares of your employer's stock as an investment option. This may seem like a smart move, but be careful not to overdo it.

Over the years, many workers have gotten hurt badly by overinvesting in employer stock, only to see hard times not only cause their retirement account balance to fall sharply but also lead to their being laid off as well. More recent episodes at Chesapeake Energy (NYSE: CHK  ) have renewed concerns about the practice.

Some companies have addressed the issue by changing their 401(k) rules on employer stock. With numerous companies including Ford and Citigroup (NYSE: C  ) having faced litigation over big drops in share prices within 401(k) plans, limits on how much of your balance you can invest in employer stock make a lot of sense.

Save now!
Your 401(k) is too good an opportunity to miss. Now that you know the rules governing it, you should feel more comfortable putting more of your hard-earned money toward a key aspect of your future: a financially secure retirement.

Ford has restored its 401(k) match, but is it on solid ground? Find out in the Fool's premium report on Ford, in which our top banking analysts look at prospects for the automaker. Click here and get your report today.

Fool contributor Dan Caplinger makes the most of his 401(k). You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Ford and Citigroup. Motley Fool newsletter services have recommended buying shares of Ford and Paychex, as well as writing a covered straddle position on Paychex and creating a synthetic long position on Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy follows the rules.


Read/Post Comments (5) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 09, 2012, at 2:43 AM, slim1070 wrote:

    In attempting to roll over my 401(k) into my Roth IRA, I discovered that, beside paying taxes, I would be required to leave the money in the IRA for an extended period of time or pay a penalty for withdrawal.

  • Report this Comment On October 09, 2012, at 4:35 PM, 123spot wrote:

    Thanks, Dan. Does the 22,500 limit include the employer match? Spot

  • Report this Comment On October 10, 2012, at 12:59 AM, jaarsrep wrote:

    Thanks, Dan. Are the rules similar for 403(b) accounts? Or are there differences?

  • Report this Comment On October 11, 2012, at 1:34 AM, mrspeabody wrote:

    The $22,500 is the amount the employee can contribute. Employer match can make the final amount higher than $22,500

  • Report this Comment On October 12, 2012, at 3:46 PM, TMFGalagan wrote:

    @slim1070 - That's a specific provision of the conversion from a regular 401(k) into a Roth IRA.

    @123spot - No, employer match is above and beyond the 17,000 or 22,500 employee limits.

    @jaarsrep - 403(b) rules are similar in many ways to 401(k), with just a few differences. If you have a 403(b), talk to your HR rep for more info on their idiosyncrasies.

    best,

    dan (TMF Galagan)

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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