Video transcript below (auto transcription can cause some errors):
Hello. This is Abhinav. I welcome you. And in this video, I’m sharing, the I’m basically sharing an understanding of 401k plans and, which are very popular, in in US as an investment option, and the taxation aspects in US. Right?
I will do a separate video on 401k taxation in India for, those who are, basically Indians who have gone to US and are planning to return to back to India. What is the taxation on, Indian side? I’ll call it in a separate video. So let us start. I’ve made some pointers.
So, 401k is basically a very, very popular retirement saving plan. It’s like a pension kind of a plan in US, and it’s named after a section in the internal revenue code, 401k. On that, it’s named as a 401k plan. Now there are various types of 401k, that the so it’s basically an employer offered plan, and, there are various types of 401k that can be offered by the employer. Traditional 401k is there.
Roth 401k, for the employers which who have, like, less than a 100 employees, then there is simple, plans and set plans. So there are different options that are there. Now what happens in 401k is that, like, in India, we have the employee provident fund where both the employer and the employee contribute up to 12% of the salary. Similar way, they are also in US. Both the employer and the employee contribute a fixed percentage of salary to this one.
Now that percentage contribution, it has to be within the overall limits maximum contribution limits of the 401k. So it is generally structured that way. Right? Now the contributions that are made are pretax, and they are deductible by the employee from his, total income, and, so that’s a big benefit. Now the maximum deductible contribution per person per year for 2024 now these limits are inflation adjusted.
So every year, the these maximum limits, they generally increase. So for 2024, it is $23,000 per calendar year, plus there is a catch up contribution of $7,500 if you’re 50 years and above. So that’s the maximum that you can contribute per year to a 4 one k. Right? If allowed, the employ employees can elect to contribute.
Now within the 401k, the allowable limit, you can also contribute employer can also allow you if he if that employer has a Roth 401k, then you can also contribute to the Roth component in the 401k. However, if you’re planning to return back to India, then maybe Roth is not advisable because the Roth taxation in India is pretty tricky. Right? So there, you don’t get the Rule 21AAA, election benefit in case of Roth, but still that option is available that you can contribute a certain amount to 401k, traditional, 401k and, a certain amount to Roth. The benefit of Roth is that, the Roth contributions are nondeductible.
You basically it’s post tax contribution, but the withdrawals are tax free. In case of 401k, traditional 401k, the withdrawals are taxable fully because they are deductible at the time you made the contribution. In Roth, it is opposite. It’s out of your taxable money, and whenever you withdraw, then the withdrawals are tax free. The contributions are tax free.
Now last date of making the contribution is December 31st, which is the end of the calendar year for US tax purposes. So, as compared to that in IRA, you get up to April 15th to contribute. So you can do post tax year planning in case of IRA. But in case of 401k, the last date you can make the contributions is December 31st. Now what is the taxation in US?
The contributions are deductible from income. Right? So whatever you contribute, you can deduct it in your tax return from your income. So straightaway, whatever is the effective tax rate of you know, depending upon your income, 10, 20, 30%, whatever is your tax rate, use that straightaway, you get that tax saving because it has got deducted from the income. However, it is not basically tax saving.
It’s basically tax deferral. Basically, what is happening is that when you withdraw the 401k, now there are certain rules on withdrawal. Now when you withdraw, they that whatever the contribution that you have made is taxable fully at graduated rates. Right? Graduated rates means as per the slab rates that are applicable.
Right? So whatever you withdraw will be taxed then fully. Right? So, essentially, the benefit is that the whatever you have contributed, the tax so, basically, you save that much tax at that time and that much more effectively, you invest that much more in your 401k, and that stays long till the time you withdraw. So, generally, there is a early withdrawal penalty if you withdraw before 59.5.
So which discourages people from withdrawing it before that age. So you get, like, 20, 25 years for that money to grow in a tax deferred way. Right? And so that is a very, very big benefit. And when you withdraw, the whatever amount you withdraw is fully taxable at graduated rates in US.
Right? So any withdrawal before 59.5 is subject to 10% penalty. However, there is exceptions. There are certain exceptions. One exception is that you are withdrawing on leaving the job after age 55.
Then there are other exceptions like, medic qualified tuition expenses, education expenses, qualified medical expenses, first home purchase, for childbirth. There are certain exceptions that are substantial periodic payments. In all those cases, the 10% penalty may not be applicable. Right? So that is the thing.
Now here in 401k, you need to take required minimum distribution after 873. Unless, you take it, penalty will apply, and, no such requirement in case of Roth. So in Roth, there is no requirement of taking, like, a minimum contribution. Right? However, in 401k, you need to take after age a particular date, which is 73, you need to take a required distribution.
If you don’t take, then I think there is some 6% penalty that is there. Now so now, generally, it is best to do a direct rollover of 401k to a traditional or Roth. So now if you move to a new employer, so, generally, best thing is to do a direct rollover. What is direct rollover? Is that you transfer your funds from the particular trustee, the of your current employer’s trustee to a new employer’s trustee, which is a direct trustee to trustee kind of a transfer.
Rollover is what? Basically, transfer. Right? So you transfer the money from you give the instructions where there is a in direct to direct transfer between the trustee to the trustee, and it is totally tax free. You can also transfer instead of new employees 401k, you can also transfer to an IRA, individual retirement account.
Now IRA, I will discuss in the next video. IRA is basically it’s not a employer provided kind of a thing. It’s basically, you can open it in any brokerage house. Right? It’s basically your own kind of an investment account, which works similar like a 4 zero one k provisions are there, that whatever contributions are there, payrolls are taxable similarly.
It’s, again, kind of a tax advantaged account, but it’s your one to 1. It’s a like, your own account. Right? Okay. Not tied to an employer’s account.
Right? So you can do a direct rule of before 401k to a traditional Roth IRA on your employer’s 401k at the time of leaving employment. Unlimited tax free any direct rollovers you do, you can do it unlimited, and they’re tax free. Right? There is if you do indirect rollover in indirect rollover, what happens is that the employer, gives a check, and that check, you deposit to the new wherever you want to open the account.
But that, you have to do in 60 days. If you don’t do in 60 days, then there’ll be it’ll be taxable. Also, there is a 20% withholding tax. So if you, you know, make the payment to the new employer, then you have to like, for the 20%, you have to put from your own pocket. So, that is not advisable.
Right? So that is the thing. Roll over to Roth IRA. If you want to roll over to a Roth IRA, then that is taxable. Right?
Because Roth IRA, you contribute from your post tax dollars. Here, you are contributing from pretax dollars. So then that is a problem because then Roth IRAs are actually from your taxable money. So you need to if you’re roll rolling over to Roth IRAs, then the you need to pay the tax on that, amount that you’re rolling over. Yes.
Final point is that you can continue these accounts if you want to continue these accounts as a nonresidential. If your 401k trustee allows for the same, then you can continue. Generally, some 401k, administrators, they don’t allow the account to be continued to a nonresident, for US tax purposes. So in that case, you will need to compulsory, transfer, rollover your account to a, IRA, which supports, nonresident, which is like, Fidelity and Schwab and all those. You need to do that.
Right? So this is basically about 401k and the taxation in US. I’ll do another video on 401k taxation in India and many other videos on the 401k and the IRA, on return to India. So stay tuned. I hope this was useful.
If you have any questions, any queries, any thoughts, do share in the comment section, and I will reply back to you. Thank you so much for watching this video. Thank you.