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10 401(k) Rules That May Catch You by Surprise

Author: Catherine Brock | June 13, 2021

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Don't get caught off guard

Your workplace 401(k) is a fantastic place to save for retirement -- as long as you color within the lines. For the basic functions of saving and investing, those lines are easy to follow. But 401(k)s can get complicated when you change jobs or withdraw funds, either before or during retirement.

Many 401(k) complications arise from obscure rules and then take shape as unexpected fees or withdrawal limitations. Here's a look at 10 of those less familiar 401(k) rules. Any one of them could easily catch you off guard, either next week or in 40 years.

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1. Service requirements

Service requirements define how long you must be an employee before you can contribute to the 401(k). The IRS allows for a maximum service requirement of one year.

A whole year without 401(k) contributions can stall out your retirement savings progress. And worse, it's easy to let your lifestyle inflate during the time you're not making those contributions.

Always ask about the 401(k) service requirements before switching jobs. If you accept a job with a lengthy service requirement, start saving to an IRA or taxable brokerage account as soon as you get your first paycheck. That'll help you keep your retirement savings plan on track and combat lifestyle bloat at the same time.

ALSO READ: Here's the Average IRA and 401(k) Balance: How Does Yours Compare?

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2. Vesting

Another pitfall of switching jobs is the possibility of losing your employer matching contributions. Most 401(k) plans have what's called a vesting schedule. It defines how long you must stay on as an employee before you "own" your employer matching contributions. This concept of ownership is important; it determines whether you can take the matching contributions with you if you leave, quit, or get fired.

A typical vesting schedule might transfer 20% ownership to you on each anniversary of your hire date. In the first 12 months, you are 0% vested. During that time, you can still earn matching contributions. You'll see those contributions on your 401(k) statements and included in your balance. But if you quit in that first year, the matching contributions will be deducted when you roll the funds to another account.

In this scenario, you must wait until five years after your hire date to own 100% of your matching contributions.

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3. Loan repayment if you leave your job

Changing jobs can also be problematic if you've borrowed money from your 401(k). You may have to expedite repayment to avoid penalties and taxes on your 401(k) loan.

401(k)s can allow loans to be repaid over five years, but that goes out the window if you leave your job. Once you're no longer an employee, you normally have until the due date of your next tax return to repay the balance in full. If you can't meet that deadline, the IRS treats any outstanding amount as a taxable distribution. That comes with a 10% penalty on top if you're under the age of 59 and a half.

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4. Force-out thresholds

If your 401(k) balance is less than $5,000 and you leave your job, your plan can transfer your money to an IRA without your consent. This normally involves selling your investments and moving the cash. If the market's down, you may incur losses in that process.

Your new IRA will automatically invest the funds in a default security that's intended to preserve capital. In other words, your funds will be invested conservatively. That may not be what you need if you're still working to grow your retirement savings.

If your balance is less than $1,000, your plan can cash you out by mailing you a check. In that case, you must deposit those funds in an IRA within 60 days to avoid penalties and taxes.

These automatic force-outs disrupt your savings growth by liquidating your investments to cash or very conservative securities. If this happens to you, minimize your downtime by reinvesting the funds as soon as possible.

ALSO READ: Is Your 401(k) Enough for Retirement?

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5. Hardship withdrawals may not be allowed

If you fall on hard times, you may not have the option to withdraw your 401(k) funds earlier than age 55. The IRS does allow for hardship withdrawals, but your plan doesn't have to offer them as an option. You may need to take a loan instead or find another source of cash.

Hardship withdrawals are generally a bad idea, so not having the option may ultimately be a good thing. A withdrawal permanently reduces your balance, while a loan requires you to repay yourself plus interest.

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6. Penalty on hardship withdrawals

If your plan does allow for hardship withdrawals, you may be surprised to get hit with an early withdrawal penalty. You'd think that having to prove your financial hardship would spare you from the 10% penalty, but that's often not the case.

Only certain situations qualify for a penalty waiver. Common ones associated with financial hardships include:

  1. Medical bills totaling more than 10% of your adjusted gross income, or AGI.
  2. Losing your job after age 55.
  3. Injury resulting in total disability.
  4. Court-ordered spousal payments.

Hardships involving tuition costs, burial expenses of a loved one, and home purchases are subject to the 10% penalty.

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7. Taxes on excessive contributions

Overcontributing to your 401(k) might seem like a good problem to have, but it's not. If you exceed the IRS' annual contribution limits, you get taxed on those funds twice -- once when you contribute and again when you withdraw.

In 2021, the IRS allows you to contribute up to $19,500 to your 401(k). If you are 50 or older, you also qualify for an extra $6,500 in catch-up contributions. Employer matching contributions do not count toward these limits.

If you accidentally contribute too much, notify your plan administrator. The plan will have to return the excess contributions plus any earnings to you before the due date of your next tax return.

ALSO READ: 3 Signs It's Time to Ditch Your 401(k)

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8. Limitations on penalty-free withdrawals

The day you reach 59 and a half is a milestone as a 401(k) saver. That's when you can tap into your 401(k) without the 10% penalty. Unfortunately, accessing your funds may not be as easy as you think.

First, you may not be able to withdraw funds while you're still working for the company. And once you do retire, there may be other limitations. For example, some plans don't allow for on-demand withdrawals. Instead, you'd have to establish systematic withdrawals on a monthly or quarterly schedule.

Ask your plan administrator for the rules governing qualified withdrawals after the age of 59 and a half. If your plan is more restrictive than you'd like, roll the funds into an IRA after you retire.

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9. Taxes on retirement withdrawals

While you do get to skip the 10% penalty, your 401(k) distributions in retirement are still taxable as ordinary income. Your plan provider may withhold 20% to cover that tax liability. If you hadn't planned for that withholding, you're headed for a serious cash flow shortage after you leave the workforce.

Your plan may withhold up to 20% from your distributions, depending on the circumstances. You will have to budget for that and also estimate your actual taxes in retirement. If the withholding percentage isn't high enough, plan on adding a line item in your retirement budget to cover the shortfall.

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10. Required minimum distributions

Once you reach the age of 72, the IRS requires you to take taxable distributions from your 401(k). These are known as required minimum distributions, or RMDs. The amount of your RMDs is based on life span estimates and the balance in your account at the end of the prior year.

Here's the sticky part. You must calculate your RMDs separately for each retirement account you own. If you have multiple IRAs, you can take your total IRA RMD from one of them. Your 401(k) RMD, though, must come out of your 401(k).

Your plan should calculate your RMDs for you, but it is your responsibility to check the numbers for accuracy. The penalty for withdrawing less than the required amount is steep: 50% of the shortfall.

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Stay informed

It'd be great if setting up your 401(k) contribution rate and investment selections ensured an easy retirement. Sadly, funding your retirement may not be that simple. You may have to manage complex and confusing 401(k) rules along the way. Several of them appear when you change jobs while you're still saving. Others crop up when it's time to use your 401(k) funds.

You can commit these complexities to memory, but there's another strategy to take. Keep an open line of communication with your 401(k) plan administrator. Check in and ask about consequences before making any big moves, with your job or your funds. That way, you can make informed decisions and minimize the bad surprises.

The Motley Fool has a disclosure policy.

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