A section 401(k) plan allows an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pre–tax basis. These deferred wages (commonly referred to as elective deferrals) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 since they were not included in the taxable wages on your Form W-2. However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.
A 401(k) plan can have an automatic enrollment feature. The employer can automatically reduce your pay by a fixed percentage and contribute that amount to the 401(k) plan unless you (the employee) affirmatively chooses not to invest 401(k) or reduce your investment percentage. These contributions qualify as elective deferrals.
Eligible Plans
In general, a qualified plan can include a cash or deferred arrangement only if the qualified plan is one of the following plans.
1. A profit-sharing plan, or
2. A money purchase pension plan in existence on June 27, 1974, that included a salary reduction arrangement on that date.
For tax years beginning after December 31, 2005, a 401(k) plan may allow employees to contribute to a qualified Roth contribution program.
Matching Contributions
In many 401(k) plans, the employer may also choose to make matching contributions to your 401(k) plan. For example, an employer contributes 50 cents for each dollar you choose to defer under your 401(k) plan.
Contribution Dollar Limit
The amount that an employee may elect to defer to a 401(k) plan is limited. This limit applies without regard to community property laws. For 2007 and 2008, the basic limit on elective deferrals is $15,500 per year. If the deferral limit is exceeded, the difference is included in the employee's gross income.
Catch-up contributions. A 401(k) plan can permit participants over the age of 50 to make catch-up contributions. The catch-up contribution limit for 2007 and 2008 is $5,000 per year. Elective deferrals are not treated as catch-up contributions for 2007 until they exceed the $15,500 limit. However, the catch-up contribution a participant can make for a year cannot exceed the excess of the participant's compensation over the elective deferrals that are not catch-up contributions.
Reporting on Form W-2
The employer must report the total amount deferred in boxes 3, 5, and 12 of an employee's Form W-2.
Early Withdrawal
In most cases, if you withdraw funds from your 401(k) plan before you are 59 1/2, you must pay the 10 percent additional tax on early distributions on any amounts that are not rolled into an IRA. However, this additional tax will not apply if the payments are made after your separation from service in or after the year you reached age 55, or if the payments are part of a series of substantially equal payments that are paid over your life.
Hardship Distribution
Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employee's elective deferrals only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions.
Exceptions to Early Withdrawal
The tax does not apply to distributions that are
1. If you are totally and permanently disabled,
2. After the death of the plan participant or contract holder,
3. After your separation from service in or after the year you reached age 55 (age 50 for qualified public safety employees),
4. Made to an alternate payee under a qualified domestic relations order,
5. You have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income), whether or not you itemize your deductions for the year,
6. From an employee stock ownership plan for dividends on employer securities held by the plan,
7. Made due to an IRS levy of the plan, or
8. Made from elective deferral accounts under 401(k) or 403(b) plans, or similar arrangements that are qualified reservist distributions.
Early Withdrawal for Home Purchase
If you are under the age of 59 1/2, any withdraw from your 401(k) plan to purchase your first home, the withdrawal is subject to a 10 percent early distribution tax. However, depending on the rules for your 401(k) plan, you may be able to borrow money from your 401(k) plan to purchase your first home. Check with your 401(k) plan administrator.
Change of Job
When you leave your job, your old employer may send you a check for your 401(k) and withhold 20% tax. You have 60 days to roll over the entire distribution (including 20% withholding tax) to your current employer's 401(k) plan without at tax implications. However, if the amount rolled over was the net amount, that is, the amount of the distribution less the tax withheld, then the 20% withholding amount not rolled over is included in gross taxable income and may be subject to a 10 percent additional tax on early distribution.
Lump Sum Distribution After retirement
A lump-sum distribution is the distribution or payment, within a single tax year, of an employee's entire balance from all of the employer's qualified pension, profit-sharing, or stock bonus plans.
If the lump-sum distribution qualifies, you can elect to treat the portion of the payment attributable to your active participation in the plan before 1974 as long-term capital gain taxed at a 20% rate. If you are born before January 2, 1936, you can also elect to figure the tax on the rest of the distribution using the 10–year tax option (Form 4972). You should receive a Form 1099-R from the payer of the lump-sum distribution showing your taxable distribution and the amount eligible for capital gain treatment.
The Retirement Benefits – Pension and Annuities
If you receive retirement benefits in the form of pension or annuity payments from a qualified employer retirement plan, the amounts you receive may be fully taxable, or partially taxable. If you contributed after–tax dollars to your pension or annuity, your pension payments are partially taxable. You will not pay tax on the part of the payment that represents a return of the after–tax amount you paid. If the starting date of your pension or annuity payments is after November 18, 1996, you generally must use the Simplified Method to determine how much of your annuity payments is taxable and how much is tax free.
Required Beginning Date
A participant in the 401(k) plan must begin to receive required minimum distributions (RMDs) from his or her qualified retirement plan by April 1 of the first year after the later of the following years.
*Calendar year in which he or she reaches age 70½.
*Calendar year in which he or she retires from employment with the employer maintaining the plan.
However, the plan may require the participant to begin receiving distributions by April 1 of the year after the participant reaches age 701/ even if the participant has not retired. If no distribution is made in your starting year, the minimum required distributions for 2 years must be made the following year (one by April 1 and one by December 31). If you do not take the distribution, the excess accumulation is subject to 50% excise tax.
To calculate the RMD, divide the amount in the account at year end by the number of years left in the owner’s life expectancy and take out that amount. Normally from the distribution, the plan administrator must withhold federal income tax at 20%.
Form 5329
Use Form 5329, Additional Taxes on Other Qualified Plans (including IRA's), and Other Tax-Favored Accounts, to report any 401(k) tax penalty.
When you withdraw from 401(k), the plan administrator will send you Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. On your tax return, report the amount in box 1 of 1099-R as income, and the amount in box 4 of 1099-R as federal income tax withholding.
Reference: IRS Publication 4222 401(k) Plans for Small Business; http://www.irs.gov/
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