Social Security & Taxation
The 401k Pension Plan
As mentioned in our guide to US social security, the retirement benefits provided by the federal government program are only meant to prevent poverty for senior citizens. They usually cover an average 40% of the recipient’s pre-retirement earnings. As such, you will get a subsistence level income, but you still need additional retirement provisions in order to live comfortably.
The most popular kind of pension plan for workers and employees in the US is the so-called 401k. This rather cryptic term refers to section 401 (k) of the US tax code. It simply describes a way of deferring taxes due on your gross income. However, it occurred to some financial advisors that this would actually make for a useful method of saving up for your retirement years.
Today, the 401k plan is widely offered by many US companies to their staff. As such, it is an occupational pension plan comparable, for example, to betriebliche Altersvorsorge in Germany or the Swiss Pensionskasse. Even if you are not planning to retire in the United States, you might want to make contributions to such a pension plan as long as you work there.
The 401k is not the only kind of retirement plan based on the tax-deferral model. Similar kinds of retirement plan are called 403b, which mostly applies to employees in public education or NPOs, 457, which covers the staff of US state and municipal governments, or TSP (thrift saving plan), aimed at federal employees. They all work according to the same fundamental principles described below.
First of all, you need to find out if your new employer offers a 401k plan and if you would like to opt in. If you want to participate, you should decide how much you want to contribute per year. In 2013, you could pay up to $17,500 in annual tax-free contributions, with additional “catch-up” payments for employees aged 50 or older.
This sum goes straight out of your monthly paycheck. It is deducted from your gross income, i.e. your earnings before taxes, and paid into your personal 401k account. Often, there are matching contributions from the company as an added benefit, so you only have to cover half the payments for your 401k plan yourself.
However, this offer might only apply to long-term staff members who have worked for the company for a specified number of years. If you’re newly hired, you may only be entitled to a certain percentage of those maximum matching contributions to your pension plan. This is called “vesting”.
Investing Your Money
Your employer usually hires another company to take care of your 401k and run the plan on their behalf. These are mostly financial service providers, such as mutual funds, brokerage or insurance companies. You can decide how you would like them to invest the money for you. The most common options in a 401k plan are investments in mutual funds for stocks or bonds.
Before you decide, though, you should probably talk to an independent investment advisor. They can help you figure out the right mixture of investments in stocks or bonds, as well as cash, to prepare for your retirement. As a rule of thumb, it’s always helpful to diversify and to avoid putting all your eggs in the same basket, so to speak. Especially if your employer offers to make matching annual payments in the form of company stock, you should make sure to include alternative options.
Generally speaking, you can’t withdraw anything from your 401 k plan before you turn 60. After all, it’s meant to be a “nest egg” for your retirement. However, every plan may have different rules for some eventualities.
For instance, you may be allowed to use part of your 401k to help you buy a home or to pay for your kids’ international school fees. Another plan might only permit you to access your savings in case of a serious medical emergency, like a total and permanent disability. Don’t wait until anything happens to you, but get the relevant information when you sign up!
If you retire in the US and still have your 401k plan, you will be able to access the account. Now it is treated just like other retirement income and usually has to be taxed. But what happens to your 401k plan if you leave the company in question before your retirement, as many expats will? There are normally several options:
- Provided that you have a minimum balance, you can just leave the sum where it is.
- You can ask for a cash-out and start investing in another scheme of your choice.
- You can take the money and contribute to a similar scheme offered by your new company.
- You can move it directly into a “rollover account” for a private tax-deferred savings plan in the US. This is very similar to a 401k and offered by many financial service businesses.
However, not all of these options will apply for every employee. In some scenarios, the deferred taxes will be due as soon as you leave the 401k plan. Always ask the investment manager, as well as your personal financial advisor, which option is best for you.
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