Distribute Income Wisely

Distribute Income Wisely

Should I decrease or suspend my 401(k) contributions to build a more solid emergency fund?

I'm currently contributing 10% of my income to my 401(k) and have about a month's worth of expenses in an emergency fund. I would like to increase the amount of my emergency fund. Should I decrease/suspend my 401(k) contributions to build a more solid emergency fund? Also, as a side note, my employer does not offer a 401(k) match, so I wouldn't be losing out there.

I would encourage you to speak with your HR department about he details of your 401(k) plan. Together you should be able to work out a "magic number" that goes directly to your 401(k) account.

A 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pre-tax basis. These deferred wages (commonly referred to as elective deferrals) are not subject to income tax withholding at the time of deferral, and they are not reflected on your Form 1040 since they were not included in the taxable wages on your Form W-2.

However, they are included as wages subject to social security, Medicare, and federal unemployment taxes.

Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employee's elective deferrals only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions.

Hardship Basics

A hardship withdrawal is not like a plan loan. The withdrawal may be difficult to get, and costly if you receive it. Remember, your 401(k) is meant to provide retirement income. It should be a last-resort source of cash for expenses before then. IRS rules allow plan withdrawals in a limited number of hardship situations. To further discourage early withdrawals; in some cases the IRS imposes a hefty financial penalty.

Two types of hardship withdrawals are permitted from 401k plans. One is called a financial hardship withdrawal. It is subject to applicable income taxes and a 10 percent early withdrawal penalty if you are younger than 59 1/2. The other is a penalty-free withdrawal made under Section 72(t) of the Internal Revenue Code. With this, you pay applicable income taxes but not an early withdrawal penalty.

Financial hardship withdrawals are allowed for the following reasons:

* To buy a primary residence

* to prevent foreclosure or eviction from your home to pay college tuition for yourself or a dependent, provided the tuition is due within the next 12 months to pay un-reimbursed medical expenses for you or your dependents

* You may qualify to take a penalty-free withdrawal if you meet one of the following exceptions:

* You become totally disabled.

* You are in debt for medical expenses that exceed 7.5 percent of your adjusted gross income.

* You are required by court order to give the money to your divorced spouse, a child, or a dependent.

* You are separated from service (through permanent layoff, termination, quitting or taking early retirement) in the year you turn 55, or later.

* You are separated from service and you have set up a payment schedule to withdraw money in substantially equal amounts over the course of your life expectancy. (Once you begin taking this kind of distribution you are required to continue for five years or until you reach age 59 1/2, whichever is longer.)

Finally, employers are not required to offer either type of hardship withdrawal, so you should check with your employer to see which type, if any, is available to you.

Now back to your question, you do not need to zero-out your contribution percentage. Remember that 401(k) contributions are pre-tax. Therefore, you should be able to, with the help of your HR department, find a "magic number" for the percentage of your gross income that is contributed to your 401(k) that creates the same amount of take-home pay if you made a zero contribution. This might be a little counter-intuitive, but run the numbers. I'll bet if you contribute 3 or 4 percent of your gross, your take-home pay will be the same as if you contributed zero percent.

I hope this information helps you Find. Learn. Save.