Note: I have also done a follow up post after this specifically for Returning NRIs holding 401K accounts: What to do with my 401K on Return to India?
In the USA, there are two types of employer based retirement plans available: defined benefit (where the money that you get on retirement is defined) or defined contribution (where the money that you invest is defined, and there is no assurance on what you get on retirement).
Over time, defined plans had become a hassle for employers to manage and now, most employers offer defined contribution plans. And amongst such category of plans, 401K is a very popular plan in the USA. Almost all of the salaried returning NRIs from the US that I’ve interacted with have an existing 401K account and are confused with what to do with their 401K money.
Today, I am going to explain more about 401K plans: features, conditions, tax breaks etc. and whether an Indian going to USA should opt for 401K, with the hope that it gives you some better idea on this investment avenue.
Basic features of 401K
Official definition of 401K as per the IRS website is as follows:
“401(k) Plan is a defined contribution plan where an employee can make contributions from his or her paycheck either before or after-tax, depending on the options offered in the plan. The contributions go into a 401(k) account, with the employee often choosing the investments based on options provided under the plan. In some plans, the employer also makes contributions such as matching the employee’s contributions up to a certain percentage. SIMPLE and safe harbor 401(k) plans have mandatory employer contributions.”
Some basic features of 401K are as follows:
- It is not mandatory for employer to offer a 401K. However, most of the employers in USA do offer this plan as a retirement savings option
- It is not mandatory for employee to contribute to 401K if employer offers this plan. Employee has to sign up for the plan, if he requires to be covered by it.
- If employer offers a separate pension plan, one can simultaneously contribute to 401K as well as such plan. However, there are separate contribution limits that apply in such cases.
- 401K is basically a deferred pension plan. Whatever amount you invest, you don’t have immediate access to it, and can withdraw penalty free after age 591/2.
- Loans can be availed subject to conditions
- 401K is creditor protected by law –this means, your creditors cannot ask the court to pay their dues using your 401K money
Contribution Limits under 401K
Both employer and employee contribution are subject to the contribution limits to 401K as follows:
- Limits for employee: $18,000* for 2016 (this limit is subject to revision every year). Participants who are age 50 or over can also makecatch-up contributions. The additional elective deferrals you may contribute is $6,000 in 2016 to traditional and safe harbor 401(k) plans and $3,000 in 2016 to SIMPLE 401(k) plans
- Limits for employer: 100% of the participant’s compensation, or $53,000($59,000 including catch-up contributions) for 2016.
Some further points on contribution limits are as follows:
- In case of multiple employers, this limit will apply for all employers taken together
- If your contribution exceeds the limits, it is known as “excess deferral” and you need to inform your employer before April 15 of the following year for refunding you the same.
- The catch up contributions shall be subject to the actual terms & conditions of 401K plan.
Where does your 401K money go?
Important question to check, and especially since it has a bearing on the 401K corpus you’re able to create after painstakingly investing that amount year after year, is that where does that amount go, and do you as an investor have any say in that?
So, your employer who offers you the 401K generally has tie-ups with asset managers like Vanguard, Fidelity etc. and you have the choice to select the mutual funds where your 401K money will be invested.
Note that in some cases, employer contributes not in cash but in its stock – there are special rules and lower taxes applicable when you withdraw – though this may act as a temptation to hold company stock in your 401K, please note working and investing in one company gives rise to concentration risk , and I don’t think it is a very wise idea – wherever possible, invest your 401K in a diversified portfolio like a S&P 500 or a Russell 3000.
Coming back to the choice of mutual funds, note that when I say you have a choice, I also mean that you have a big responsibility to select the right mutual funds. Mutual funds can be of varied types, domestic equity (i.e. US equity), international equity, bond/fixed income, target date funds etc. – so, you MUST develop some kind of competency to first understand the risk-return equation in each fund, get a hold on your own risk tolerance and OVERALL asset allocation and then select the funds which are best suited for the long term financial goals.
The worst mistake you can do, and if you plan to stick to your 401K till 59.5 is to invest completely in US fixed income – probably when you reach your retirement, you would realise your mistake that had I invested in equity, the accumulated corpus would have been totally different.
Understand this: your time horizon is very very long (if I assume you are 30 years old, you have another 30 years to go) – and so, it makes a lot of sense to hold max. part of corpus in equity.
When I say equity, there also, I mean domestic equity i.e. USA equity – again this is with my belief that there are only 2 strong markets worth investing for a long term – USA and India (your opinion on this could be different, but I’ve seen a lot of people burn hands in investing in those exotic international and china type funds – so, to each his own)
If you need professional help on this, it is wiser to pay a small fee to a Registered Investment Adviser (RIA) in USA rather than choosing wrong funds and repenting later.
Also, speaking about US equity, there is nothing like a Vanguard S&P 500 Index – pure index with no active management and rock bottom fees. I guess similar passive options will be available with other asset managers as well, which are empanelled for your 401K – you need to ask the right questions.
Fees for 401K plans
401K plan involves certain fees. Since this fee goes on to reduce the net return from your investment, you need to pay careful attention. As per the law, the fee has to be “reasonable” and hence there is no set limits on the fees. There are following main categories of fees:
- Plan Administration Fee
- Investment Fee (includes sales charges, management fee & other fee)
- Individual Service Fee
You can’t do much about the fees here, and I don’t think it widely differs from employer to employer. Yes, on the investment fee, if you select passive funds, you can considerably save in the long term by way of a lower investment fee.
You can read more on fees here: A Look At 401(k) Plan Fees
USA Taxation of 401K
Apart from promoting systematic deferral for long term financial goals, the second biggest attraction is the tax deduction one gets from investing in this plan.
The money you invest in the plan and the earnings on those contributions are deferred from income tax until you withdraw the money. Withdrawals are included in the taxable income however if you withdraw post your retirement, you can expect yourself to be in one of the lower tax brackets & hence the tax impact is likely to be a lot lesser.
In case you withdrawal from 401K plans before the age of 59-1/2 years, there will be two implications:
- The withdrawal amount will be subject to a 10% federal penalty tax.
- The withdrawal amount will be included in your income for the purpose of federal as well as state taxes.
A good resource on calculating early withdrawal penalties is a calculator by Wells Fargo Link
As regards Indian taxation of 401K for a returning NRI, it is quite complicated hence I have discussed in this separate post: What to do with my 401K on Return to India?
What to do with 401K you’re changing employers:
If you change jobs, leave your savings invested in your current retirement plan, or roll them over to an Individual Retirement Account i.e. IRA (something like a Vanguard IRA) or your new employer’s plan. There are no tax implications for such a rollover/ transfer. If you’re returning back to India and are winding up your US investments, there are multiple strategies you can choose to transfer your money to India, with the minimum pain.
Some tips on making the most of your 401K
Following are some tips available at the DOL website & apply generally to all defined contribution plans:
- Study your employee handbook and talk to your benefits administrator to see what plan is offered and what its rules are. Read the summary plan description for specifics. Plans must follow federal law, but they can still vary widely in contribution limitations, investment options, employer matches, and other features.
- Put in the maximum amount allowed.
- If you can’t afford the maximum, try to contribute enough to maximize any employer matching funds.
- Study carefully the menu of investment choices. Some plans offer only a few choices, others may offer hundreds. The more you know about the choices, investing, and your investment goals, the more likely you will choose wisely.
- Join as soon as you become eligible.
- Many companies match employee contributions with stock instead of cash. Financial experts often recommend that you don’t let your account get overloaded with company stock, particularly if the account makes up most of your retirement nest egg. Too much of a single stock increases risk.
Retirement planning options apart from 401K
- Apart from 401K (or if your employer does not offer a 401K), there are other options too. You can put up to $5,500 a year into an Individual Retirement Account (IRA). Contributions to IRA are also tax efficient and operate mostly like a 401K. When you open an IRA, you have two options: a traditional IRA or a Roth IRA. The tax treatment of your contributions and withdrawals vary and will depend on which option you select.
Also read: Understanding Traditional and Roth IRA
- There is now a new type of Roth IRA introduced by the U.S. Department of the Treasury known as myRA, a retirement account that can help you save for retirement if you don’t have access to a plan at work. For more information, you can visit mygov.
The big question: Should an Indian moving to USA opt for 401K?
401K in USA has a lot of similarities with the Employee Provident Fund (EPF) that we have back in India. Just like EPF, when you contribute to 401K, your employer is obligated under law to contribute an equal matching amount. The amount contributed is tax free in USA – In India though, apart from being tax free, it also qualifies for a tax rebate u/s 80C of Income Tax Act.
In many cases, employee is allowed to contribute even more than minimum matching contribution. For example, employer will say that it will match contribution to the extent of 6% of salary of employee. However, over and above, 6%, employee is allowed to contribute to say 15% without employer match – much like Voluntary Provident Fund (VPF) in India.
So, assuming both employee and employer contributes 6% each, 12% of salary of employee becomes TAX FREE.
Well, you cannot say tax free, better way to put it is, that it becomes TAX DEFERRED. Because when you withdraw it, the withdrawal is included in your taxable income. This way, 401K is different from EPF where the withdrawals after 5 years of continuous service is 100% exempt.
However, rather than comparing 401K with EPF, let us come back to whether an Indian moving to USA should contribute to 401K or not.
Look, one thing is clear: 401K is an excellent scheme; your taxes are deferred, which allows you to invest more and benefit from the power of compounding. At the same time, your tax slab in USA at the time of withdrawal will be very less, thereby allowing you to minimise your overall tax liability.
However, understand two things:
- Any early withdrawal before 59.5 can be very costly, especially in view of the 10% penalty tax – and this tax is on the withdrawal amount, not just the earnings – so, practically, this penalty can wipe off a good portion of your earnings from your 401K.
- If you plan to return to India after some years, understand that the Indian taxation on 401K is a grey area – should you defer the income every year, or offer it to tax in India every year, there is no clear guidance either from tax authorities or any legal precedent. Also, there are severe implications under the Black Money Law in India if you fail to disclose any foreign assets, and this includes 401K.
I would like to clear one thing here: 401k is a good scheme but it does not mean, you MUST have it. It all depends on the individual circumstances and one should jump in after knowing the implications and doing some thinking.
Against this backdrop, my view is as follows:
- Before investing a single USD in 401K, make it clear in your mind that you’ll keep it till 59.5 and not withdraw it earlier except in case of an emergency where you don’t have an option – if you don’t have that clarity, DO NOT opt for 401K – also stop crying about the missed tax benefits and listening to people who claim it is foolish in not investing in 401K
- If you are very clear that you’ll not withdraw before 59.5, choose the right funds (preferably Vanguard like passive and total market funds) considering your overall investment allocation (USA + India), allocate 401K to your retirement goal in your financial plan (or ask your Investment Adviser to do it). If you’re planning to return to India, have the right strategy in place to rollover your 401K into an IRA till the time you have RNOR status – discussed more in a follow up post – contact a CA in India specialising in cross border tax to clearly understand the Indian tax implications of holding a 401K while being an Indian resident.
- If you’re going to USA for a short term assignment (say on H1B or L1 visa) and DO NOT have a clear idea whether the assignment will be extended to a long term one, or you plan to find another job in USA, wait before jumping in – again, please don’t cry!
Additional resource: IRS resource guide on 401K
Also read my follow up post: What to do with my 401K on Return to India?
Note: My understanding on US tax law is limited. I advise you to seek professional advice from a licensed CPA before taking any investment or tax decision.
Hope the post has been of service to you. Please share your thoughts/feedback in the “comments” section below.