Retirement Planning: The Basics of the 401(k)
By Michele Blandino
What exactly is a 401(k)? Simply put, 401(k) plans are employer sponsored salary deferral retirement savings plans. Unfortunately, that’s the simple part – the rest of the explanation is slightly more complicated.
Putting Money In
The first thing you should know about 401(k) plans is that they allow you to defer a portion of your salary each year (up to $13,000 this year, increasing by $1,000 each year until 2006) meaning, the more you contribute, the lower your income tax liability. Here’s an example: You make $40,000 a year. Therefore, you pay taxes on $40,000 each year. If you contribute $5,000 to your 401(k) plan, you will only pay taxes on $35,000. Sound good? Keep reading; it gets better.
The beauty of the 401(k) plan is that you can contribute as much or as little as you are comfortable with. Most plans allow you to change your contribution amount from year to year, so you can adjust the amount you defer as your need for more (or less) cash changes.
And, like most retirement plans, any earnings you manage to accumulate in your account remain tax deferred until they are withdrawn.
The second thing you need to know is that many employers will match your contribution. So, if you contribute $1,000 per year, your boss may match that contribution with $1,000 of his own. Some employers even match 2-for-1.
Getting Your Money Out
And, lest you think that this money, once contributed, will be locked away forever (or until you retire, which right now may seem like forever), take heart. Many plans have provisions for in-service withdrawals and/or loans. While taking money out of your account using one of these methods usually isn’t recommended, it’s nice to know the option is available. Keep in mind though that if you choose to take a loan from your plan then decide to leave your company before the loan is repaid, the unpaid balance will probably be considered a distribution from the plan and will be subject to a number of taxes, most notable, the 10% penalty tax for early withdrawal. Now you see why loans are not highly recommended!
Many plans also offer the option of making after tax contributions. Unless you have lots of money to spare, this is probably not something you will consider.
Most 401(k) plans also have eligibility requirements meaning you will have to be a certain age and/or have fulfilled certain length of service requirements. Ask your employer about the eligibility requirements for your plan.
Investment Choices
Ok, so you’ve opened your account and are dutifully putting money in it. Now what? Well, one of the first things you will need to do is figure out how to invest it.
When you sign up for the 401(k) plan, you will be given information which lists (and, in excruciating detail, describes) the different investment options. In general, your choices will likely be among money market or stable value funds (low risk, low reward), bond funds (moderate risk, moderate reward), and company stock and mutual funds (high risk, potentially high reward).
How you invest really comes down to your tolerance for risk. If the rise and fall of the stock market makes you nervous, then you will probably be better off with a low risk portfolio. Your account won’t grow as quickly as you might like, but at least you won’t need to worry about moving in with your kids during your retirement years! If, on the other hand, you can reconcile yourself to the fact that any gains or losses aren’t “real” until you actually sell your investments, then maybe you will be more comfortable with a little more risk.
Like your contribution percentage, your investment allocation can be changed – how often depends on the parameters of your plan – so don’t feel like you will locked into the investments you choose.
One last thing to consider: many investment advisors will warn against investing too heavily in your employer’s stock. This is probably good advice. Let’s face it; no one knows where the next Enron might be lurking.
So, let’s review: 401(k) plans allow you to save for retirement while lowering the amount you pay in taxes now, your employer will likely contribute some money to your account each year, and you can take money out if you really need to.
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