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Financial Literacy Month: Your 401(k) and 2012 Contribution Limits

by on April 10, 2012

By Meghan Stewart

Continuing with day 2 of our Retirement Roundup for Financial Literacy Month, we’re taking a look at the most common retirement accounts and the benefits each one offers. Although most benefit salaried employees have a 401(k) or at least an option to use one, unfortunately not everyone knows what it is, how it works, and how to best use it to prepare for retirement.

If you’re already familiar with your 401(k), the next thing you need to know is the contribution and catch-up limits for 2012:

  • 2012 contribution limit: $17,000
  • 2012 catch up limit for contributors over age 50: $5,500

Of course, if you’re like many Americans, these two numbers may actually tell you very little, because you simply don’t understand exactly how your 401(k) works. Furthermore, you probably filled out your employment benefits a while ago and you may not even know what percentage of your salary is being contributed to your contributions accounts. It’s hard to know if you’re close to reaching the contribution limit if you don’t know what you’re contributing to start with!

So, here’s a quick and easy explanation of how your 401(k) works and what you need to know when it comes to managing this essential retirement investment. A 401(k) is a defined contribution retirement plan offered through your employers. This means you define how much you contribute and your employer deducts the money from your paycheck and serves as the sponsor of your plan. In some cases your employer may offer contribution matching—meaning they contribute money that equals all or at least a portion of what you contribute. You have to check your benefits agreement to see if your employer offers a 401(K) match program. For example, some employers will contribute half a percent for every 1 percent that you contribute to your 401(k).  Of course, there are usually additional stipulations on this type of agreement.  Another example, if you contribute 6% to your 401(k) every paycheck, your employer has agreed to contribute half which would be 3% but you only receive the full 3% that he contributed if you work at the same company for a certain period of time – typically 5 or more years.

Once the money is contributed, that’s basically the end of your employer’s involvement. The money is then invested by a plan administrator—typically some kind of mutual fund or insurance company. You can decide how to invest the money from a few different options offered by the administrator—usually mutual funds. In a few cases with a public company, you may be able to invest in stock shares of your employer. The money builds over time as your investments grow—unless you have an aggressive investing strategy selected and the market crashes as it did with the Great Recession of 2008, where many people lost at least a portion of their 401(k) retirement savings.

After you turn 70.5, you are required to make minimum withdrawals from your 401(k). You can withdraw the money early, but if you withdraw any money anytime before you reach the age of 59.5, you get a 10% withdrawal penalty. In some cases, your plan may allow you to take out the money early without a penalty if the money is used to do something like buy a house or pay for higher education.

If you leave your job before you retire, you can usually move the money into another type of retirement account like an IRA or even your new employer’s plan. Some employers will even let you leave the money where it is to continue to grow—typically if you already have $5,000 invested. Keep in mind if your company has a match program, the money has to be “vested” before it’s totally yours—i.e. the money your company contributes has to sit there for a few years before you can cash it out. Always check the specifics of your plan and if you have any questions, ask your human resources department for help.

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