Life Advice

401(K) Plans

Many Americans today are living longer, healthier lives which could mean additional retirement years for which you MAY have to provide an income. It’s up to you to make yours a comfortable retirement. In most instances, Social Security alone won’t provide the necessary level of preretirement take-home pay you’ll need once you quit working. That’s where a 401(k) comes in.

Fortunately, you may have access to a powerful retirement tool that can provide a portion of your retirement income—a 401(k) plan provided through your employer. What you get out of a 401(k) depends on how much you put in and how wisely you invest your monies. Here’s how to help yourself reap the full benefits of your plan.

What Is a 401(k) Plan?

A 401(k) plan (named after a section of the tax code) is an employer plan established by your employer that lets you set aside a percentage of your pay before taxes are taken out. A 401(k) plan is generally funded with your before-tax salary contributions and often matching contributions from your employer. Both the employer contributions (if any) and any growth in the 401(k) is tax-deferred until withdrawn. Similar to an Individual Retirement Account (IRA), a 401(k) is designed primarily as a retirement savings plan. Once money is in your 401(k), you generally cannot make withdrawals before age 591/2, except for special circumstances. Many employers, however, include loan provisions in their plans. Today 401(k) plans are offered by many employers in place of a traditional pension.

A 401(k) plan allows you to contribute up to a certain percentage of your before-tax pay, which varies based on your employer's plan. The IRS establishes the maximum dollar amount that an employee can contribute from before-tax pay. See the chart below.

Additionally, if you are age 50 or older, you are allowed to make catch-up contributions. That is, you are allowed to contribute extra amounts over and above your before-tax contribution limit. The before-tax contribution limit is increased as follows:

Thereafter, the limit is indexed for inflation in $500 increments. 

There are several substantial benefits to 401(k) plans that can make them a valuable part of your overall retirement plan:

• Any employer contributions and earnings on your 401(k) account grow tax-deferred. Since employer contributions and earnings are not taxed until they are withdrawn, you have more real dollars working for you. With taxes deferred, your account balance may grow more quickly.

• Your current gross income is reduced by the amount you contribute. Contributions are usually made pre-tax, which means you do not pay Federal (or most state) income tax on your contributions to the plan until the money is withdrawn, typically at retirement. You may be in a lower tax bracket at that time and would therefore pay less tax. This also means you have more money in your account working for you. Contributions are subject to Social Security and Medicare taxes.

• Automatic payroll deductions make saving for retirement easy. You’re less likely to miss money you never see.

• You control your own account. Unlike a traditional pension plan, most plans allow you to choose how to invest your contributions to your 401(k) account. You can be as aggressive or as conservative as you wish in selecting your investment options.

• The plan is “portable.” When you leave your current employer, you have the option of rolling your 401(k) money over into an IRA (Individual Retirement Account) rollover plan or a new employer’s plan or withdrawing the money. Keep in mind, however, that withdrawing money before age 59½ will mean you will pay taxes on the withdrawal and generally are assessed an early-withdrawal penalty of 10%.

• You can invest in professionally managed funds at no minimums. Retail financial service providers may impose minimum investment requirements, often $1,000 or more. With a 401(k) you can get started investing a little at a time.

• You may be able to borrow from your account. Many plans have loan features that let you withdraw money (without taxes or penalties) as a “loan to yourself.” You pay the loan back automatically through payroll deduction, and the loan interest goes into your own account, too.

• Your employer may contribute “matching” funds on a portion of your savings. If so, you reap instant earnings on your investment. For example, if your employer contributes 50% of the amount you contribute, you would receive an additional $50 added to your account for every $100 you contribute, up to the plan limits. Matching contributions can be a fast track to money growth.

Not all employers make matching contributions, and those who do contribute at different levels. A typical match might be 25% to 50% of your own contribution up to a certain level. Your own contributions to your 401(k) plan are automatically yours to keep, but you may have to be “vested” before you are entitled to your employer’s matching contributions. This means having a certain level of service with your company, often three years. Some plans have graduated scales for vesting. For example, you may be 50% vested after two years and 100% vested after three years. With other plans, you may be entitled to your employer’s contributions immediately, without waiting to be vested.

Usually you are eligible to join a 401(k) plan if you:

• are an eligible employee of a company that offers such a plan.
• are over the age of 21.
• have worked for the company for a certain period of time (not to exceed 1 year).

For full information on the rules governing your employer’s 401(k) plan, ask your plan administrator or human resource representative for a Summary Plan Description (SPD).

What Are Your Investment Options?

Most 401(k) plans offer a number of investment options for your money. A typical plan may offer six–to–eight options, but some offer an even broader range. It’s up to you to decide how to divide your money among the available options. The choices you make will have a tremendous impact on the ultimate value of your 401(k), so it just makes good sense to educate yourself about the potential risks and rewards of each type of financial vehicle available to you. You may put your money in just one option or you may divide your contributions among various options—some high–risk and some low–risk. Among the possibilities that may be available to you are the following:

Stable Value Funds. These funds are designed to provide consistent, predictable growth over the long term. Sometimes called the “Fixed Fund” or “Guaranteed Fund,” these funds are typically backed by contracts issued by insurance companies, such as “Guaranteed Interest Contracts” or “GICs.” This option is generally considered low risk and is guaranteed by the issuing insurance company, but fixed interest rates and rising inflation can erode its earning power. Be sure to check the financial health of the companies issuing the option’s GICs and other contracts. Financial ratings of insurance companies are issued by companies such as Moody’s, A.M. Best or Standard & Poor’s.

Company Stock. By selecting your employer’s stock, you acquire an ownership interest in the company. Buying the stock of any single company—including your employer, however, carries a very high degree of risk and generally should represent only a small portion of your investment portfolio.

Mutual Funds. These options pool money from many investors and can invest it in various securities such as stocks, bonds and money market instruments, and are designed to help reduce (but not eliminate) risk. If you further diversify by purchasing shares in more than one plan option, your risk may be reduced even more. Among the types of accounts that may be available to you in your 401(k) plan are:

Money Market Funds. The assets in these funds typically consist of U.S. Treasury bills, Certificates of Deposit (CDs) and other commercial investments. You’ll find them on the lowest rung of the risk ladder. On the other hand, they also offer the lowest potential for return and may not beat inflation. These funds are generally not insured nor guaranteed by the U.S. Government and there is no guarantee that they can maintain a stable net asset value.

 

Bond Funds. Bonds represent loans to Federal or local governments or to a corporation, with a promise to repay at a set interest rate in a predetermined period of time. Bonds are generally considered a safer investment than stocks. However, they are sensitive to interest rate fluctuations. That means both your principal and the interest rate will rise and fall with changes in the general market interest rates. In addition, long-term performance may be outpaced by inflation. In general, high-grade bond funds are low- to moderate-risk investments, with a few categorized on the high-risk side. Independent agencies such as Standard & Poor’s and Moody’s rate bonds in the marketplace according to default risk.

Balanced Funds (Life Style Funds or Asset Allocation Funds). Blending both stocks and bonds, these funds allow diversification with potentially lower risk than pure stock funds, but also with a lower potential for return.

 

Stock Index Funds. These funds attempt to “mirror” the performance of stock market indexes, such as the S&P 500. These indexes are unmanaged and are commonly used measures of stock market performance. No direct investment can be made in an index. Index funds invest in most or all of the same stocks found in the corresponding index and, accordingly, seek to closely match the performance of that index. Generally, they are adjusted to assume reinvestment of dividends. This middle-of-the-road approach puts index funds at the low end of the risk spectrum for stock funds.

 

Growth and Income Funds. Such funds invest in companies with strong growth potential that also have a solid record of paying dividends (income). Growth and income funds fall in the middle of the risk spectrum.

 

Growth Funds. Investing in relatively stable and established companies, which may or may not pay dividends, these funds try to identify companies whose stock values are expected to increase. Growth funds are considered higher risk, so expect significant fluctuation in share price in exchange for a potentially higher return.

 

Aggressive Growth Funds. These funds are comprised of stocks with greater-than-average potential for growth. Such stocks may include start-up companies, smaller companies or companies in high-risk industries. As a result, these funds also have a high degree of risk and a high potential for return.

 

International or Global Equity Funds. International stock funds invest only in stocks from countries outside the U.S., while global funds invest in both foreign and U.S. companies. Investors in these funds take on a higher degree of additional risk, since international issues contain risks not present with domestic issues, such as currency exchange rate fluctuations and different economic conditions, governmental regulations and accounting standards. The risks and potential rewards are very high.

Each type of investment has its own degree of certainty and uncertainty. Since all investments perform differently, one way to manage risk is to diversify your portfolio by investing in a blend of different types of assets. Keep in mind that 401(k) options are not Federally insured, and past performance is not a guarantee of future results.

To choose the best investment for you, ask yourself these questions:

• Have I learned all that I can about each investment? For mutual funds, good sources of information are the prospectus, financial magazines, or your plan administrator. For other types of options, ask your plan administrator for information on the investment.

• How has this investment performed in the past? While past performance is never a guarantee of future performance, it will help to give you an idea of how the different types of investments have performed over time.

• How long do I have before I’ll need the money? If you can leave money in a 401(k) fund for 10 to 15 years or more, you may be able to ride out the ups and downs of the stock market, and over time stocks have generally outperformed other options. Keep in mind that some 401(k) plans limit the number of times you can transfer your contributions from one option to another. Some plans let you switch monthly, others quarterly or yearly, while some others allow transfers on any business day.

• How should I “mix and match” my investments? Don’t put all your eggs in one basket! Most financial professionals recommend that you allocate your assets by placing some money in conservative investments with stable rates of return and some in more aggressive investments that carry more risk but have potential for greater returns. Your particular asset “mix” should reflect your needs for return, safety, and long-term savings needs. Keep in mind that your ideal mix of investments will shift over time.

• Am I a conservative, moderate or aggressive investor? Conservative investors run the risk of losing earning power if their account growth does not outpace inflation. On the other hand, the winner-take-all attitude of aggressive investors holds the potential both for great gain and great loss. To help determine where your tolerance for risk (conservative, moderate, aggressive) lies, review the statements below.

Conservative or Low-Risk Investor:

• I don’t want to risk any of my principal.
• I want a guaranteed rate of interest on my investment.
• I am near retirement.

Moderate or Medium-Risk Investor:

• I can live with some ups and downs.
• I would like a combination of high- and low-risk investments.
• I have some time for my money to grow.

Aggressive or High-Risk Investor:

• I have an iron stomach and can handle market swings.
• I want the highest possible long-term rate of return, even if I risk losing short-term principal.
• I have at least 10-15 years for my investments to grow.

Whatever your investment philosophy, you should never put money in an investment you don’t understand. And don’t forget to review your investment strategy periodically, especially as you draw nearer to retirement or when you experience changes in your life, such as getting married or divorced or having a child.

What If I Leave My Current Employer?

Your investment is portable—you can take the money with you. When you switch employers, you have several options regarding your 401(k) plan money, each with its own tax implications.

• You may be able to leave the money with your former employer. This may be convenient, but you will not be able to continue to contribute to the plan or borrow from it. If your total vested account does not exceed $5,000 (for years beginning 2002, disregarding rollover amounts, if your employer’s plan so provides), you may not have this option.
• You may be able to withdraw the money. If you are over 59½, and you take your money in a lump sum, you’ll pay ordinary income tax on the amount. If you are under 59½, and take your money in a lump sum, you’ll generally pay regular taxes plus a 10% tax penalty.
• You can transfer your 401(k) to a new employer’s plan. If the transfer goes directly from your old plan to the new, you avoid having taxes withheld. If you withdraw any of the balance, even temporarily, taxes will be withheld and penalties may be due. Not all employers will accept money from a previous 401(k) plan.
• You can directly transfer the money to to a traditional IRA. Establish a special "conduit IRA." Do not mingle the money from your 401(k) with any other or you will lose the option of one day transferring the money to another employer's 401(k) plan. Beginning in 2002, the rule that you cannot mingle your rollover with any other money no longer applies. However, another employer's plan does not have to accept your rollover from a traditional IRA. Again, make sure the transfer of money goes directly from institution to institution to avoid having taxes withheld.

If you should die, any money in a 401(k) plan, including all employer contributions, will go to your named beneficiary. If that person is your spouse, he or she will have the same options outlined above. But a beneficiary who is not your spouse will not have the rollover option. Instead, such a beneficiary will have to take the money, either in a lump sum or over a period of years not to exceed his or her life expectancy (as determined by IRS regulations).

What If I Need the Money Before Retirement?

Through plan loan features, many employers allow you to borrow up to one-half of your total vested account, up to $50,000 (reduced by any outstanding loans). If, for example, you are fully vested and have accumulated $20,000 in your 401(k) account, you could borrow up to $10,000. Using payroll deductions, you repay the principal and current interest rates back to your account over a set term (generally not more than five years unless used for the purchase of your principal residence). In effect, you repay yourself. Immediate repayment may be required if you terminate your employment. Loans do not incur the taxes or penalties of a withdrawal.

Many plans also permit hardship withdrawals, usually for the purchase of a primary residence, payment of post-secondary education expenses, payment of certain unreimbursed medical expenses or to prevent the eviction from or foreclosure of your principal residence. Qualified hardship withdrawals are subject to a 10% Federal income tax withholding and may be subject to a 10% early withdrawal penalty. Your plan may not allow you to make additional contributions for a period of time after a hardship withdrawal. If your plan so provides, you also can withdraw money without withdrawal penalties if you are medically disabled as defined by the IRS.

Other withdrawals taken before the age of 59½ (for example, if you change jobs and don’t roll over your account) will generally incur the 10% penalty in addition to regular income taxes. Unless you are still working for the same employer, you must begin taking minimum distributions by April 1 of the calendar year following the calendar year in which you reach age 70½. Such distributions must begin by April 1 of the calendar year following the calendar year in which you reach age 70½ or retire (except for more than 5% stockholders of the employer), whichever comes later. Be sure to talk to your lawyer or financial advisor before making any withdrawal to be sure you fully understand the tax consequences. Under some plans, you may be required to commence distributions at age 70½ while you are still working. Other plans may allow you to choose to begin distributions at age 70½ or defer the commencement of your distributions until you retire.

What Is a 403(b) Plan?

Similar to 401(k) plans and also named after a provision in the tax code, a 403(b) plan is a retirement savings plan for certain employees of public schools and certain tax-exempt organizations. You contribute to your 403(b) tax-deferred until you withdraw money. Ordinary income taxes are generally due upon withdrawal. Withdrawals prior to age 59½ are generally prohibited. Those that are allowed may be subject to a 10% tax penalty.

Some Tips for Savvy 401(k) Investing

An employer is legally required to provide a Summary Plan Description (SPD) of your 401(k), including information about eligibility, vesting and benefit payouts. However, employers are not required to distribute prospectuses and financial statements on the investments themselves. Information on your plan’s investment options may come from the investment manager directly. Remember, a prospectus is required by law for all mutual funds. To make sound judgments regarding your 401(k) plan, you’ll want to know the following:

• What is the maximum amount/percentage you can contribute?
• What is the percentage your employer will match? Is there a minimum amount you must contribute before the matching contribution kicks in? Is there a maximum?
• How many years of company service are required before you are fully vested in your employer’s contributions to your 401(k)?
• How often can you transfer money between the investment options in your plan?
• When are earnings on contributions credited to your account—daily, monthly, quarterly? Earnings on contributions that are posted more frequently generally compound faster.
• How often are account balance statements provided?
• How can you access your account? Can you get updates or make transfers via computer, phone or written correspondence?
• What is the history of the investments you have chosen? Review the investment information provided with your plan. Educate yourself by spending some time online and at the local library, and read publications such as The Wall Street Journal, Barron’s, Business Week, Money, Forbes, Fortune and the monthly Standard & Poor’s Stock Report.
• Have you sought financial advice? You may want to consult a financial advisor, attorney, accountant or tax advisor about your family’s future needs.
• Have you allocated your assets? Distributing your money across different types of investments is generally the soundest way to help reduce risk and enhance returns.

Make the Most of Your 401(k)

Remember, the key to maximizing your 401(k) contributions is to start early and contribute as much as you can. Set aside the maximum amount allowed, or at least try to increase your contributions each year. And always take full advantage of any matching contributions your employer might make.

Careful planning today may help you remain one step ahead of tomorrow’s inflation and can help provide you with the money you’ll want to enjoy your retirement years.

For More Information

REFERENCE MATERIALS

401(k) Take Charge of Your Future

Eric Schurenberg, Warner Books                                   $10.95

The Complete Idiot’s Guide to 401(k) Plans

Wayne G. Bogosian, Dee Lee

MacMillian Distribution                                                     $19.95

A Commonsense Guide to Your 401(k)

Mary Rowland, Bloomberg Personal Bookshelf            $19.95

PAMPHLETS FROM THE FEDERAL GOVERNMENT

The quarterly Consumer Information Center catalog lists more than 200 helpful federal publications. For your free copy, write: Consumer Information Catalog, Pueblo, CO 81009, call 1-888-8-PUEBLO or find the catalog on the Net at www.pueblo.gsa.gov.

ADDITIONAL SOURCES

To learn more about 401(k) plans contact:

Financial Planning Association at 1-800/322-4237 or www.fpanet.org.

Internal Revenue Service at www.irs.gov

RELATED LIFE ADVICE® PAMPHLETS

See other Life Advice® pamphlets on related topics: Investing for the First Time, Planning for Retirement, 403(b) Plans, Building Financial Freedom, Enjoying Retirement, Choosing a Financial Advisor, Annuities, Mutual Funds and Lump Sum Distribution. To order up to three free pamphlets at a time, call 1-800-Met-Life, that’s 1-800-638-5433.

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