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Arbitrary Retirement Plan Rules, Part 1: 401k Plans

Every day you realize you're growing older. Some day you may not be able to work. Even if you don't want to retire, you must entertain the idea that you may be forced to stop working. What happens then? Well, you'll have to live off of Social security and your savings. What if you don't have any savings? Well, then you may be destitute and dependent on other people's charity unless you can manage to survive on what the government pays you in Social Security benefits.

Even with a Social Security safety net, what happens if the bottom drops out of the government's plan and your Social Security check must be cut or your retirement age must be increased or the whole system collapses? The only real solution to relying on the government is to take responsibility for your own retirement and rely on your own savings. But, assuming you have money to save, where do you put all of this personal savings? In this series of posts, I explore various popular retirement savings strategies and the inherent problems that you face when attempting to formulate a plan for your future.

The 401(k)

One of the most popular retirement savings strategies is to pool money into an employer sponsored retirement plan, called a 401(k) plan, and attempt to accumulate a personal savings that is sufficient to support yourself after you retire.

A 401k plan is an employer sponsored retirement plan that gets is name from sec. 401 of the Internal Revenue Code. Subsection (k) outlines the general requirements for these plans. By "employer sponsored" I mean a plan which is only available through an employer. This means that you must be working for another company in order to participate in a 401(k) plan. There are two types of plans: the traditional 401(k) and the Roth 401(k).

The essential benefit that is advertised here for traditional 401(k) plans is the ability to defer the payment of income taxes on the portion of your salary that is contributed into the plan. The essential benefit of the Roth 401(k) is the elimination of all income taxes on money withdrawn from the plan after your 59th birthday.

Both traditional and Roth 401(k) plans, however, rely on arbitrary and changing rules. This, in my opinion, makes them somewhat unpredictable in terms of assessing the true benefit of the plan over the long-term. The three areas I want to discuss are the contribution rules, the withdrawal rules, and rules that pertain to accessing the money prior to your retirement age.

Contribution Rules

First, all 401(k) plans are subject to contribution rules. These contribution rules change over time. While they generally trend up, there is nothing in the Internal Revenue Code that mandates that they must do so. for example, from 2009 to 2011, the contribution limits have remained unchanged. Contribution rules prevent you from contributing more than a set dollar amount to the plan. For 2011, this limit is set at $16,500 for individuals under the age of 50 and $22,000 for individuals 50 and over. These limits may or may not seem rather high to you depending on how much money you make and how much you want to save. Regardless of this, the IRS sets an arbitrary limit on how much you are allowed to contribute to the plan.Traditional 401(k) plans allow pretax contributions. Which means contributions to your 401(k) plan are deducted from your paycheck before taxes are deducted from your paycheck. Contributions to Roth 401(k) plans are always made with after-tax dollars (contributions are made after taxes are deducted from your paycheck).

Withdrawal Rules

Second, withdrawing money from the plan is difficult to do unless you are at least 59 years old. There are limited instances when you may withdraw money from your 401(k) plan. These include instances when you need to pay for certain medical bills or you are making a down payment on a home or you want to pay for college expenses. Even when you turn 59 years old, the rules for withdrawing money from your account do not end. You must take it upon yourself to think ahead, since you are required to take withdrawals from your 401(k) plan by your age 70 1/2. These withdrawals must be made according to mortality tables found in table III of the appendix in IRS publication 590. If you fail to make withdrawals according to this schedule, the IRS will take you out to the guillotine. Which means, a massive 50 percent penalty is assessed on the money that you should have withdrawn but did not. When making withdrawals, you must pay income tax on 401(k) plan withdrawals, while Roth 401(k) plan withdrawals are tax-free.

Moving or Removing Money Prior to Retirement

Moving your money during your working years is also restricted. You may only transfer your money into another 401(k) plan or an Individual Retirement Account, but only if you leave your current employer. The exception to this is if your employer allows an "in-service withdrawal." The IRS allows, but employers are not obligated to offer, a transfer of your 401(k) account before you have left your employer. You must be at least 59 1/2 years old to move the money without incurring a penalty, however. If you attempt to withdraw money from your 401(k) account prior to age 59 1/2, then you are assessed a 10 percent penalty on the amount of money you withdrew in addition to having to pay ordinary income taxes on your withdrawal amount (for Roth 401(k) plans, all penalties are on investment gains only, not principal amounts). To avoid this penalty, you may borrow money from your 401(k) plan. Borrowing money from your account is like borrowing money from yourself. The difference is that the IRS mandates that you must repay this loan prior to leaving the company you work for. If you don't, you are again assessed a 10 percent penalty and must pay income tax on the amount you failed to repay.

...and...all of these rules represent just the essential rules of 401(k) plans, not all of them. On top of that, all of these rules are subject to change at any moment by the IRS.

Is this getting complicated yet?

It could be that 401(k) plans are beneficial for you. They might help you accumulate a retirement savings. I say they might because my argument is that all of the rules concerning 401(k) plans are completely arbitrary. Why are the contribution rules capped at $16,500 and not $17,000 or $13,000? Why does the IRS allow withdrawals for college education and the purchase of a first home but not for the pursuit of other important financial goals? Will 401(k) plans continue to offer the same tax benefits in the future?

Many financial planners suggest the use of a 401(k) plan, almost as if it were inherently good. What you must realize is that, if you decide to use a 401(k) plan, you are accepting a government tax favor. This favor, like all favors, comes with "strings attached". These "strings" are the rules that prevent you from having complete control over how much you may contribute towards your future savings, how much you can withdraw (and when) as well as under what circumstances you may use the money for purposes other than retirement income. You must be willing to accept the arbitrariness of the IRS's rules and realize these rules can change in the future, just as they have changed in the past. Some of those changes, if they occur, won't necessarily be in your best interest.

This post is part of a series on retirement plans. Want to read more? Here's the rest in the series:

Arbitrary Retirement Plan Rules, Part 1: 401k Plans

Arbitrary Retirement Plan Rules, Part 2: IRAs

Arbitrary Retirement Plan Rules, Part 3: Annuities

Arbitrary Retirement Plan Rules, Part 4: Employer Pension Plans

Arbitrary Retirement Plan Rules, Part 5: A Solution

This entry was posted on January 10th, 2011 by David C Lewis, RFC. Edits may have been made to keep this entry current. · 3 Comments · Retirement Planning

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