Know the rules before you tap your 401(k)
By Alan Klayman
Dear Maturing Loans,
Can you be taxed on money you withdraw from your 401(k) retirement plan to put into a bank CD? With the economy the way it is now, I would hate to lose most of the money I have put into my 401(k) because of the stock market. -- Pam
Your question really brings up a number of issues that are on many people's minds: the stock market, retirement nest eggs, investing, and how retirement plan assets (like a 401(k)) are treated.
Let's start with a distinction. There are different types of investment accounts that have specific rules associated with them. Let's look at two broad categories: retirement and nonretirement.
Retirement accounts have names like IRA, 401(k), 403(b), pension and profit-sharing. Nonretirement accounts have names like individual account, joint account and tenants in common.
In these accounts you can have investments. For example, you can own a bank CD in an IRA, and you can also own a bank CD in an individual account. The type of investment is not necessarily tied to the type of account you have. You can own mutual funds in your joint account, and you can also own mutual funds in your 401(k).
Which brings us to some of the rules. A 401(k) plan is an employer-sponsored defined contribution plan, which means that your employer sets up the plan, and you choose how much money you want to put into the plan each year. That amount usually is a percentage of your earnings and is subject to limitations set by both your employer and the federal government.
One advantage of a defined contribution plan, like a 401(k), is that the government allows you to make contributions with tax advantages. Your tax advantages are set by the type of plan your employer chooses. Typically, the plan allows you to deduct your contribution from your income, allowing you to grow your money tax-free now, and then you pay taxes when you use the money at a later date. Some plans do not allow for a tax deduction based on your contribution, but your money still grows without being taxed. When you use the money at a later date, you don't pay taxes on the original investment or the growth of the account (this is called a Roth 401(k)).
So back to your question. If you are withdrawing money from your 401(k), the first question that needs to be asked is whether your plan allows withdrawals. Many 401(k) plans do not allow withdrawals unless they are for hardship purposes, or they allow you to borrow from your plan, but then you must pay back what you borrowed along with a set interest rate.
If you are no longer working for the employer that enrolled you in the 401(k), then you can roll the 401(k) plan over to an IRA and invest in just about anything you want, including bank CDs, mutual funds, and many other types of investments. Withdrawals from 401(k) plans are taxed. Borrowing is taxed if you do not pay it back. Borrowing is not taxed if you pay it back. Rolling over your plan from a 401(k) to an IRA is not taxed.
Which leads to the last point. Does getting out of your mutual funds -- 401(k) plan or any other type of plan -- really make sense? Unfortunately, my crystal ball is broken, so I can't tell you what will happen in the future, but I can give you these guidelines. Keep in mind everyone's situation is different. You need to seek the help of financial professional and perhaps a tax adviser in order to get questions answered that specifically address your situation. If your goal to use your money in your 401(k) (or any other plan for that matter) is long term, then invest in a diversified portfolio that is professionally managed (like mutual funds). If your goal is to use this money in the short term, you should look at fixed investments.
Thanks for your question, see you back here next week.
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Published: October 8, 2008
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