When should you start saving? Start saving as soon as possible with the best retirement plan available in the market. One of the most popular ways to save for your retirement is 401(k) plan.
In this article, I will discuss about the 401(k) plan in the US and pointers that an NRI should know.
What is 401(k) plan & What does it mean for US Indian?
401(K) plans are tax-deferred retirement savings plans for employees and are sponsored by the employers. They are part of a family of retirement plans known as “defined contribution” plans – the amount contributed is defined by the employer or the employee. 401(K) gets its name from the section and paragraph of the Internal Revenue Code – section 401, paragraph K. The implication of this plan is that it lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.
How does 401(k) plan work for H1, L1 Visas?
401(k) amount is solely the discretion of the employee, as you join the 401(k) plan, you can tell your employer how much of money you decide to set apart to your account.This amount is deducted from your salary before taxes are applied, hence in a way you end up paying less income tax. A good thing about 401(k) plan is that the money is deducted even before the employee receives it. This makes it the easiest saving plan to make the contribution for. Also, you have the complete right to make use of this one and you can choose from a plethora of options like investing in mutual funds, bonds, money market accounts or any other investment vehicles with a guideline for the level of risk you are willing to take.
Additionally, to oversee the account, your employer usually hires an administrator like Fidelity Investments. They’ll email the updates about the current plan and its performance, manage the paperwork and assist you with requests. In case you want to alter or shift your money around, you can directly contact your administrator.
This is a plan that acts as an incentive for retirement savings but it comes with one condition, if you happen to withdraw the money before you are 59.5 years old, then the account holder has to pay the tax as well as 10% penalty fee to the IRS.
Eligibility to participate in 401(k) plan
Some employers keep a waiting period of a month to one year before you are eligible to start participating in the 401(k). Whereas some other employers allow employees to begin making the contributions instantly.
What is the contribution amount?
The Internal Revenue Services (IRS) sets a maximum limit of contribution to a 401(k) plan in any given year and it is ideally adjusted upward to account for inflation. In the year 2016, the maximum contribution that can be made by an employee is $18,000.
401(k) plans let the employees contribute a percentage of the covered compensation, in whole percentages, up to a specified percentage – usually up to a maximum of about 20 percent to 25 percent of covered compensation. (Covered compensation means total salary.)
What are the different types of 401 (k) plan for Immigrants?
Generally, they come in two varieties. The prominent differences being the tax implications and the schedule for accessing your funds. Most of the companies offer a traditional 401(k). Here’s the breakdown of each.
|401(k) type||Tax Rules||Withdrawal Rules|
|Traditional||Wages are contributed before taxes from each paycheck, like a deferred salary.|
Taxable income drops by the amount you contribute.
You pay income taxes on contributions and earnings upon withdrawal.
|No access to your funds before age 59 ½ or if you leave your employer at age 55 or older.|
If you dip in early, expect a 10% penalty — on top of the usual tax bill.
|Roth||Contributions are made with money that’s already been taxed.|
No taxes paid upon withdrawal.
|Better flexibility: free access to your money as long as you’ve held the account for 5 years.|
Is 401(k) plan a good option for H1B visa holders?
It is of course not very easy to make a decision about the future especially when you have plenty of time for the retirement. But it is always good to plan ahead and save early when you have a very busy and demanding career. 401(k) plan hold extremely helpful for an H1b visa holder. It is highly advisable to join the plan if your employer is offering one.
I am jotting down few of the reasons why it could be useful to join 401(k) plan:
1.Contributions to the 401(k) plan are free from State and Federal taxes. You have to pay taxes only when you withdraw. One good thing is if you are in a lower tax bracket when you retire, you will owe fewer taxes.
2.The USP of 401(k) plan is the contribution made by the employer. This is equivalent to free money. You are getting an ROI of 100% for every dollar your employer matches.
3.401(k) plan allows you to take loans against the money you have contributed to this plan. Loans will be issued for financing a home, health problems etc.
4.If at all you decide to withdraw the money earlier, the penalty that you pay at the end would be lesser than the actual tax that you will be paying on a monthly basis.
Here is the math to give you a better clarity:
Your salary : 150K
Employer contribution: 100% match up to 4% of annual salary
Taxes : 30%
Scenario where in you invest in 401(k) plan:
1.Your contribution of 4% of annual salary – $6000
2.Employer match 4% of 150K – $6000
3.Total contribution : $6000+$6000 = $12000
If you decide to withdraw from the plan after one year. You will pay 10% penalty plus 30% tax . So you will end up getting 60% of $12,000 = $7200
Scenario where in you do not invest in 401(k ) plan:
You will be paying 30% taxes on $6000 and you will end up using 70% of $6000 = $4200
So did this math help you decide? $7200 Or $4200?
What to do when you change/leave/lose the job?
This is a scenario that can happen to type of residents like H1b, L1/L2, GC or a citizens.There are three options to avoid paying the income tax and penalty fee in this situation
1.Keep the money in your former employer’s 401(K):
In order to do this, the account holder needs to have a vested amount of at least $5,000 in your account to choose this option. Also, you have to be under the plan’s normal retirement age.
No immediate action is necessary
Earnings remains tax deferred until you withdraw them
You can no longer contribute to a former employer’s 401(k).
Depending on your employer’s plan, your investment choices may be limited and managing multiple funds will end up being complicated.
2.Roll the money over into a new 401(K):
If you decide to go with this option, make sure that the check is written directly to the new 401(K) account. There is no grace period for this option. There are situations where the money was transferred directly to the account holder’s bank account and they end up paying tax and penalty fee for it. So avoid such unnecessary confusions, go for direct transfer to the new 401(k) account.
Assets in a 401(k) are typically protected from claims by creditors
Fees could be higher than with your former employer’s 401(k).
Cash out: You can withdraw the money in your 401(K). However, if you are under the age of 59.5, the income tax and 10% penalty fine will apply. If you are 55 years or older, you can begin tapping into your 401(K) and the 10% penalty will not apply.
Cash can help you through any extraordinary financial troubles.
If you leave your job between ages 55 and 59½, you may be able to take penalty-free withdrawals.
Taxes and penalties for cash distributions can be hefty, and your savings will no longer grow tax-deferred.
Roll it over to an IRA (Individual Retirement Account): You also have an option to rollover the 401(k) account into a traditional IRA (Traditional IRA may give you more flexibility in managing your savings. Traditional IRAs are tax-deferred retirement accounts.) or Roth IRA (Roth IRA can help you continue to save for retirement while letting any earnings grow tax-free.)
Remember that your Social Security Number will be always valid (whether you live in the US or abroad), however, your finances and investments in the US are affected by various factors including your status in the US and how often you visit or live in the US among other things. For more details, NRI’s should contact the attorney or any law firm. Click here for more details: http://www.murthy.com/
Your money can continue to grow, tax-deferred or tax free, depending on the IRA
You may be able to consolidate several retirement accounts into your IRA
Your assets from an IRA are typically protected from creditors only in the case of bankruptcy.
What are the Pros & Cons of 401(k) plan?
Qualified workplace retirement plans are protected by Federal law called Employee Retirement Income Security Act. They set a minimum standard to be followed by the employers and the administrators who manage them.
Those employers who have opted to offer the 401(k) retirement plan must also offer to match the contribution made by the employee.
Every time you get a raise or hike in your paycheck, you add more contribution towards the plan.
Get the free financial advice from the 401(k) provider and most of the providers are the major brokerages like fidelity or Vanguard or Merrill Lynch.
If you compare some of the traditional retirement plans like IRA or a typical taxable brokerage account, the investment options found for 401(k) plan remains limited. That is if you are planning to invest on some exotic bunch of options rather than the normal stocks, bonds etc.
As mentioned earlier, the 401(k) plans are managed by a an outside administrator. Hence, the managing cost remains expensive.
This is one of the biggest disadvantage of this plan – the early withdrawal penalty. It literally takes a lot of time to taste the fruit of your hard work and if you end up paying penalty if you decide to withdraw before the maturity period.
What a L1/L2 visa holder should know about 401(k) plan?
This is a question pondered upon by many of the L1/L2 visa holders who tend to stay in the US for a specific period of time. Do they need to invest in 401(k)? What will happen to the money when they leave the country?
The answer received had both good and bad opinions. A bunch of Indians stated that 401(k) plan does not hold good for L1/L2 visa holders because of their short stay and uncertainty.
But on the contrary, I also received inputs stating that it is good enough to start the 401(k) plan if the employer is ready to match the contribution made by you. And when you are ready to move back to India, rollover the 401(k) to Traditional IRA at Fidelity/Vanguard or another investment company. Do not forget to give the Indian mailing address to Fidelity/Vanguard when you move. You can keep the IRA account in the US until the retirement. When you reach the retirement age, withdraw from IRA and pay US taxes on that withdrawal.
Why saving is important?
Here’s how time and compounding impact a $5,000 pre-tax yearly contribution when saving starts at various ages.
Image source: www.fidelity.com
Little things make a big difference in life. If you are planning to make a huge difference in the way you want to lead your life after retirement, a small decision to make a contribution of even 1% every year at the initial age would be adequate. So to begin with, it is ideal to start with a simple plan like 401(k), particularly if you have a considerable amount of annual income and a good employer match. Not only that, 401(k) plans are an important part of your employee benefits package and the best saving vehicle to choose from. Do not miss this privilege while you are in the US. Start planning well ahead!