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401a

Money Manager | Monday, September 15th, 2008

What is a 401(a)?

A 401(a) is a type of retirement plan available through certain employers. Contributions of money into your plan are made through your employer and the employer makes most of the decisions about how the plan is set up. Contributions can be made by the employer, you the employee, or both.

What are the advantages of a 401(a)?

The advantages of having a 401(a) plan is that it effectively increases your after tax income since contributions are deducted before your income tax is calculated. Since most employers set up a system where contributions are automatically deducted out of your paycheck, the dollar cost averaging effect takes place. Dollar cost averaging spreads the cost of the investment over a long period of time which can provide protection from fluctuations in market prices; the opposite of dollar cost averaging would be to make one huge purchase of investment assets once. Dollar cost averaging allows investors to eventually build up a large amount of investment assets by incrementally buying them over a long period of time.

Also, if you ever change employers, your contributions are your property so you do not lose any of the money deducted from your paycheck if you change jobs. You also have the option of putting any 401(a) money into a 401(k), 403(b), 457, or Traditional IRA.

401(a)’s also provide tax advantages. Any earnings on your contributions are tax-free until you begin to make withdrawals when you retire. So if your 401(a) money is invested in mutual funds, you will not owe any income tax on the dividends earned until you make a withdrawal from your 401(a). Also, if your employer offers a 457(b) plan, you can participate in both at the same time.

Do I have to meet certain requirements to participate in a 401(a)?

There are usually participation requirements set up by your employer. Common examples include being a full-time employee, having worked for the company for a certain number of months, or having completed a certain number of hours of work for the company.

How will money be deposited in my 401(a) account?

The plan can be set up with employer-only contributions or matching contributions. The employer will decide how the plan will be set up. If there are matching contributions, a fixed amount will be deducted from each of your paychecks and deposited in the 401(a). If contributions are only made by the employer, then the employer will periodically deposit money into your 401(a) account.

You should receive account statements every so often detailing the balance and activity in your 401(a) account.

When can I withdraw my money from a 401(a)?

You can withdraw your money at any time. However, if your withdrawal is an early distribution, you will have to pay an extra tax on the withdrawal.

What is an early distribution?

An early distribution is any money taken out of your 401(a) before reaching age 59 ½. Early distributions are subject to a 10% tax, so if you withdraw $5,000 from your 401(a) when you are 45, you will have to pay $500 in taxes. However, as discussed in the following question, there are some exceptions that allow you to withdraw money before age 59 ½ without owing the 10% penalty.

Are there any other circumstances when I can withdraw my 401(a) money before age 59 ½?

Yes, there are some exceptions to the age rule. You will not owe the 10% tax on an early withdrawal if the withdrawal is:

1. Made to a beneficiary after your death.

2. Made because the employee has a qualifying disability.

3. Made as part of a series of substantially equal periodic payments.

4. Made after separation from service if the separation occurred during or after the year when the employee reached age 55.

5. Made to an alternate payee under a qualified domestic relations order (QDRO).

6. Made to an employee for medical care.

7. Timely made to reduce excess contributions under a 401(a) plan.

8. Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).

9. Timely made to reduce excess elective deferrals.

10. Made because of an IRS levy on the plan.

11. Made a qualified reservist distribution.

Are there any limitations to making a contribution to a 401(a)?

Yes, you are limited by IRS rules and by whatever rules your employer implements in his 401(a) plan.

IRS Contribution Limitations

There are many IRS rules dictating limitations on contributions to 401(a) plans. They can get fairly complicated and involve many calculations. Check with your plan administrator or financial advisor for more detailed information, but be aware that there are limitations to the amount of money you can contribute to a 401(a) each year.

Employer Limitations

When your employer sets up his 401(a) plan, he can place limitations on contributions. The plan can be set up so that employees can only contribute up to a certain percentage of their paychecks. An employer can decide to set up his plan in a variety of ways, so be sure to get clarification and explanation of your employer’s rules.

Can I start a 401(a) if I already have an IRA?

Yes, you absolutely can participate in a 401(a) if you also have IRA’s, Traditional or Roth.

How does a 401(a) affect my federal income tax?

401(a) contributions are considered “elective deferrals” of income, so you do not pay any federal income tax on them in the year you make the contribution. For example, John’s employer contributes $1,000 to his 401(a) in 2007. John’s salary for the year is $30,000. He will pay federal income taxes on $30,000 only, which is his salary without the employer contribution included.

However, you do not get away completely tax-free. When you take distributions from your 401(a) plan during retirement, you will pay federal income taxes on that money then. For example, if Susan is age 65 and receives a $10,000 distribution from her 401(a) in 2007, she will owe taxes on the $10,000. However, when she contributed to the plan years ago, she did not have to pay any taxes on the money she contributed then.

What happens to my 401(a) after I die?

You may designate beneficiaries who will inherit your 401(a) after your death.

Why participate in a 401(a)? Why not just invest that money in mutual funds?

By participating in a 401(a), you receive tax benefits that you would not receive by investing your money in mutual funds on your own. The money contributed to your 401(a) is not subject to income tax. Therefore, you end up paying fewer taxes by participating in a 401(a) than if you bought mutual funds on your own. Another reason is that it effectively increases your compensation from your employer. If your employer makes $1000 of contributions to your 401(a) in 2007 above and beyond your base salary, you effectively get an additional $1000 in compensation for which you do not owe federal income taxes.

This article has covered common questions investors typically have when learning about 401(a) plans. This article does not cover all aspects of the 401(a), but it is designed to give you an overview of what the plan is and how it works. For additional information or specific questions, contact your plan administrator or financial advisor.

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One Response to “401a”

  1. Charles Kern says:

    I was employed at the Caddo Parish Public Defenders Office from March 19, 2007 to April 30, 2009. My position was eliminated due to the State of La. budget cuts to the public sector. I went to work the following day May 1, 2009 at the Bossier Parish Public Defenders Office. During my tenure with the Caddo PDO I participated in a 401a (no contributions on my part) and I was told that my contributions had to stay with the Caddo PDO and could not be transferred to the Bossier Parish PDO, who said they would accept the funds and start new contributions to the plan. I’m at conflict at what is and is not applicable, and I don’t want to lose the funds I have in the Caddo fund, even though I did not financially contribute. Thanks
    Charles Kern
    206 Teche
    Bossier City, LA 71111

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