401(k) Plans
How to start investing in a 401(k) Tax Deferred Account
If you work for an employer who offers you a 401(k) plan, you may want to consider contributing as much as you can, especially if the employer is matching contributions.
There are some advantages to a 401(k) plan. First, the money is taken out of your paycheck before taxes are taken out of your paycheck. Also, it does force you to save for retirement automatically. A big plus.
Second, contribution limits can be higher than a traditional IRA, depending on
your income and the terms of the plan offered. Usually you are allowed to contribute up to 10% of your income. In 2005 that limit was fourteen thousand, rising to fifteen thousand in 2006. If you are over fifty, you are allowed extra contributions of four thousand in 2005 and five thousand in 2006.
Third, the money invested is pre-tax. In other words, you don’t pay Social Security, Medicare or any other withholding taxes on the money contributed to a 401(k).
Fourth, if your employer matches your contribution, you have a built in return on your money. But it gets tricky and its best to read the prospectus for the plan and check with your HR department. For example, you can contribute up to 6% of your salary, and you make $30,000 a year, you could invest up to $3000 each year. Your employer could contribute an additional $900 each year.
There are some downsides to a 401(k) plan. Among them are: you might be limited in your investment options, although some plans offer two or three types of investment options: your employer’s contribution might not full vest immediately, in other words, if you’re fired or quit before a certain time period you won’t be able to keep the employer’s contribution: also an employer might may make his contribution in the form of company stock, instead of cash (which is better) or might limit your investment to company stock only (not a good idea).
If company stock is the only option you may want to pass. Too many companies have gone under dragging employees’ retirement savings along with them. Remember Enron? Longterm employees who had everything in the retirement plan saw their entire retirement go down the drain. Vanish overnight.
It is alway better to diversify your investments, putting money in stock, bonds and maybe savings of some sort. Spread it around so you wont lose everything. An investment in an S-500 Index Fund is diverse enough.
Over the last few decades many employers have been using 401(k) plans in lieu of offering a traditional retirement pension plan of their own. They are literally transferring the risk of meeting investment goals from themselves to their employees. You now are responsible for your own retirement, but it is not that easy. 401(k) plan prospectuses and paperwork are not easy to understand with companies spending thousands in meetings trying to explain them to their employees.
Many financial experts think employees are too timid with their investments. Rightly so. They just don’t understand the plans or all the fees they charge. Many would say you should put a good portion of your 401(k) investment into more aggressive investments, which fluctuate in value, but which generally could have a higher rate of return. Invest your money and forget about it is what many teach. Just what an employee should not do, instead they should actively watch their investments.
Finally, these plans are not insured like pension funds use to be. You can lose a good portion of your fund and still be charged fee on the amount before the loss.
Some of the other benefits of a 401(k) plan is that they can be moved around. If you leave, or get fired from, your job, you don’t lose your investment. Depending on the plan, you are usually allowed to leave your money in some employers plans if you wish, or roll it over into a tax deferred IRA.
Some plans also allow you to borrow from them, but it is best to check the plans rules. You are actually borrowing from yourself and repaying yourself with interest. You should not do this if your job is in jeopardy, since you only have a very short time to repay it and if you are laid off or you will face IRS penalties and taxation.
Also, if you stop contributing to the plan you miss out on your employer’s contributions, which can turn out to be a very expensive loan indeed. If you forgo the employer’s contribution for 5 years, the lost contributions and the money you would have earned on them, will deprive you of thousands of dollars at retiremnt. Also, fee are taken out, even if there are no contributions to the plan which erodes your investment.
Yes, you can contribute to both a 401(k) and a traditional IRA each year. Unlike a Roth IRA, this money is taxable when you withdraw it. But if you have enough of it, what harm is there is paying a little tax? Actually a lot, which is discussed in other articles on this site.
A September 2006 Update: 401(k) Rule Change
The government is making an effort to encourage participation. It used to be you had to "opt-in" to your employers plan to be included. Now you have to "opt-out". Otherwise your employer will enroll you at a certain minimum level. You should check with your HR department.
The more dramatic change is the new "Roth 401(k)" plan. Until this change, money you - and your employer - paid into your account was not taxable. So if you were in the 20% tax bracket, a $100 contribution "cost" you only $80 because you were paying with pre-tax dollars.
A Roth 401(k) is now more like a regular Roth retirement account. You get no deduction for your contributions, but your money grows tax free – just like a Roth investment. The major benefit is that all withdrawals are tax free upon retirment. Like Roth IRA's the money has to have been in the account for a minimum of five years before this tax break kicks in.
Is it worth it to switch over? A Roth 401(k) plan is more complicated than the IRA transfer. You are dealing with higher contribution levels in most cases and the present tax benefit makes a 401(k) an attractive investment. If your contribution remains the same, the after tax cost of the investment will go up.
Your assumptions about tax rates when you retire and how close you are to retirement come also into play. So before you jump into a Roth 401(k) plan, sit down with a CPA or a Certified Financial Planner to see if the changes make financial sense in your present circumstance.
It is always best to stay on top of your investments and stay educated to produce the best results.
