All About the 401k
May 12, 2009 by Paul Walsh | Category: Investing
Every working American is entitled to the financial rewards promised by a 401(k) plan. And yet a third of the American workforce let these rewards slip through their fingers, and down the drain. Why does this happen? Some explain it by a lack of information, or not “understanding” what a 401(k) is in the first place. Many feel intimidated by it’s official-sounding name, and don’t want to be bothered.
The 401(k) may as well change it’s name to the Free and Simple Way to Save Plan.
What is a 401(k)?
A 401(k) plan is a retirement fund. Each company has its own unique 401(k) plan, but they are all generally the same thing. It is an employment benefit provided by an employer, much like vacation days and health insurance. However, your 401(k) benefit can be considered free money, and should be considered more valuable than most other benefits provided.
401(k) plans offer simple and smart ways to save.
You (the employee) selecting a percentage of your income, or a “contribution”, to be transferred into your 401(k) account, which is set up by your employer. (Note: self-employed workers can set up 401(k)’s as well.) The money is transferred pre-tax, which means you get the full benefit of what your salary is, on that percentage. You will eventually pay the taxes on this money (hopefully upon retirement), once you are probably in a lower tax bracket.
Invest in your future. In today’s economic climate, investing in your future is extremely important. Safekeeping your money in a 401(k) plan enables you to automatically save a little bit each month, in a sound and secure way. Think of it as protecting your earnings, while deferring tax deductions, and possibly receiving even more money in the form of “matching contributions” by your employer (see below).
Free tax-breaks. By deferring a portion of your earnings toward a 401(k), you reduce your taxable income, since usually your contributions are made before tax is deducted from your salary. This results in you paying less tax, for the same salary. Once you withdraw your money, you will owe tax on the income but will likely be in a lower tax-bracket.
5 essential tips for your 401(k)
1. Calculate your contribution.
Figuring out how much to contribute each month will require you to estimate how much you’d like to save by the time you retire, and work backwards to see how much is required from you each month.
Know your limits, and act accordingly. See if you can set aside 10% of your income – a nice, round number, recommended by most financial advisors – and go from there.
There is a “401(k) limit” on the amount you are able to defer per year, which is set by the IRS on a yearly basis. (In 2009, this limit was $16,500, or $22,000 if you are over the age of 50.) Your employer may have its own additional limits on the amount you can defer each year. These limits are likely to rise due to inflation.
2. Plan your investment strategy.
Your employer will offer you some options from which you will decide how your 401(k) money should be invested, so that it can earn its maximum potential. Your employer will likely offer a mixture of stocks, mutual funds and bonds.
Before deciding how much to invest and in what form, you must recognize: (a) the amount of time you have left before retirement, and (b) your personal risk tolerance. Stocks tend to be riskiest; in exchange for uncertainty, they offer a greater possibility of return. They are better conceived as a long-term investment, and not a reliable way to quickly earn money (or to quickly lose your savings!)
Even if you don’t understand (or don’t want to understand) the options provided by your employer, don’t decide to simply forget about your 401(k) altogether. Stay focused! Talk to your benefits provider or human resources rep for additional help, or simply invest in an index fund (for example, the Dow Jones and Standard and Poor’s 500), which provide a reliable method of gaining returns, in exchange for low fees.
3. Match contributions
As an added bonus, some employers offer to “match” the contributions you make toward your 401(k) plan. This may sound too good to be true, but it’s one of those rare gifts in life that come around once in awhile. Find out from your employer if there is a minimum amount you must contribute to qualify for their matching contribution, and be sure to devote at least this much to your 401(k) plan to fully benefit.
4. Changing jobs and “rolling over” your 401(k)
- (a) Leave it alone. Leave your 401(k) money where it is, in the plan set up by your old employer.
- (b) “Roll over” the money out of your old 401(k) account and into a new one, as provided by your new employer.
- (c) Transfer your 401(k) into an IRA (Individual Retirement Account). If your new employer doesn’t offer a 401(k), this may be the best choice.
Whatever you do – don’t cash out. You will owe penalty fees, and taxes on the money withdrawn. No to mention you will effectively terminate your own retirement fund.
If you do decide to transfer money either way, request from your new employer a “trustee-to-trustee transfer”. This allows your new employer to transfer the money directly from the old 401(k) account. Otherwise, you have 60 days to deposit the money yourself from your old employer into the new account, and you run the risk of incurring late penalty fees, not to mention the automatic 20% withholding for income taxes your old employer will take. In short: make it a “trustee-to-trustee” transfer!
5. Manage early withdrawals and loans wisely.
401(k) plans are retirement plans, and need to be treated with proper respect by those investing in them. Our government is encouraging us to plan for a better future for ourselves – so be smart about it! 401(k) plans are not schemes by which to arrive at fast cash. Having a nice chunk of change set aside that grows year after year might tempt you into tapping, but beware:
If you withdraw your 401(k) prematurely (i.e. before retirement – 59.5 years of age) you will have to pay a hefty price: income taxes on the funds withdrawn, plus a pesky 10 percent penalty fee for early withdrawal.
Of course, emergencies and unforeseen events do occur every now and then. Check the fine print of your 401(k) to see what qualifies as a “hardship” withdrawal; you may be able to get a reduction in penalties in certain occasions such as medical fees, funeral expenses or education payments.
A nice option, if you really are strapped for cash, is to loan yourself money from your own 401(k) plan. If you absolutely must dip into your retirement fund, a self-owed loan may be a reasonable tactic, as the interest will go towards yourself. However, if you suddenly find yourself out of that particular job, the loan is due immediately. So consider this option wisely.
Don’t Waste Another Day – Start Investing Now!
Don’t be part of that 1/3 of people who out of negligence miss out on a valuable benefit. When it comes to making the most of your salary, and planning your future ... it’s never too late to start. Sharpen your knowledge of what 401(k) can do for you – and prepare for a better future, now!
