What You Can and Cannot Do With 401(k) Plans

Money roll for 401K with coins.
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If you work for a large employer, you likely have access to a 401(k) plan. If so, it’s important to take maximum advantage of it, because it’s one of the most tax-advantageous accounts you can have — and your employer may make annual contributions on your behalf as well. But even with the ubiquity of 401(k) plans, many workers are unfamiliar with just what they can and cannot do with them. Here’s a brief overview of some of the most important provisions of a 401(k) plan.

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Can: Take a Loan

Although you should never deplete your retirement savings except in the case of an extreme emergency, most plans do allow you to take loans. If permissible, you can borrow the lesser of 50% of your vested account value or $50,000. Loans are typically paid back over three to five years, and you pay the interest on the loan back to your own account. Although not generally an advisable strategy, it’s good to know that if you’re really in a bind the 401(k) loan option is permissible according to IRS regulations, although not all employers allow them.

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Cannot: Freely Leave Your Company If You Have a 401(k) Loan

You can obviously leave your company if you quit or get fired, but if you have an outstanding 401(k) loan, you might have to be careful. When you leave your employer, you generally have to pay back your outstanding 401(k) loan within short order. If you don’t have the cash to do that, your loan will be treated like a distribution from the IRS, which could be disastrous financially. Not only will you owe ordinary income tax on the amount of your loan, but you’ll also have to pay a 10% early distribution penalty if you are not yet age 59 1/2. 

Can: Contribute on an After-Tax Basis

Although not all plans permit this, the IRS allows for after-tax contributions to a 401(k) plan. What this means is that when you withdraw that portion of your 401(k) in retirement, your entire distribution will be tax-free, not just your earnings. Typically, this type of 401(k) is known as a designated Roth account, or simply a Roth 401(k). Contribution limits on after-tax 401(k) contributions are the same as with pretax contributions, but both types of contributions must be added together for purposes of determining whether or not you remain within the limits.

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Cannot: Exceed Annual Contribution Limits

Regardless of the type of 401(k) plan that your company offers, you’ll have to abide by the annual IRS contribution limits. For 2021, the limit on employee elective deferrals is $19,500, rising to $20,500 in 2022. If you’re 50 or older, you can contribute an additional $6,500 in both 2021 and 2022. For 2021, the total amount that can be contributed to your account, including your own contributions, your employer’s contributions and any other additions, is the lesser of $58,000 ($64,500 including catch-up contributions) or 100% of your earned compensation. 

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Can: Rollover to Another Retirement Plan

If you change employers, you don’t have to leave your 401(k) plan behind. In fact, in many cases, employers won’t allow former employees to maintain accounts with them, and you’ll be forced to bring it with you. The good news is that 401(k) plans are portable, meaning you can roll them over into other retirement plans. If your new employer has a 401(k) plan, for example, you can roll your former plan into your new one, with no tax consequences. If your new employer doesn’t offer a retirement plan, you can open an IRA and roll your 401(k) plan into that. Bear in mind that if you do roll over your 401(k) plan into an after-tax account, like a Roth IRA, you’ll owe ordinary income tax on the entire amount you convert. Consult with a tax advisor for more information if you plan on going this route. 

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Cannot: Invest Beyond the Parameters of the Plan

One of the main drawbacks of a 401(k) is that your investment options are limited to what your plan administrator offers. In most cases, this means a range of mutual funds. Some plans are better than others, however. The best plans offer a wide variety of investment options, but some may only have a few stock or bond funds to choose from, usually in an effort to reduce employer costs. Although a 401(k) plan can be a great tax-deferred investment option, especially if your employer offers matching funds, in most cases you cannot pick your own stocks, cryptocurrency or other investments.

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