The 411 on the 401(k)

What the heck is a 401(k) and how does it work?
I remember the first time I ever heard of a 401(k) plan. I was barely twenty-one years old, and was just hired for my first good job that offered benefits. At the time, I didn't really understand much of what the human resources director told me about it all, except that I could buy company stock, they would match part of what I put in, and that it all came out of my check before taxes.

I anxiously agreed to contribute a certain percentage of my weekly paychecks, thinking that I had struck a goldmine; I hadn't ever experienced another time in my life that an employer would give me money for saving money. Well, I worked at that job for a couple of years, and ended up cashing in my 401(k) for some reason that was important at the time.

I imagine there are others who are like I was back then, folks who haven't yet learned much about investments, tax strategies, and retirement planning. They land their first big job out of college, and their employer asks them, "Would you like to participate in our company's 401(k)?" They may wonder about the details, but know that EVERYBODY says that you should take advantage of a 401(k). So they do. Well, they've made a smart choice -even if they don't really know all the details.

The Tax Reform Act of 1978 spells out the details of the 401(k) plan in paragraph 401, section K of the Internal Revenue Code. A 401(k) plan is an employer-sponsored, tax-advantaged retirement plan for employees. Each company chooses how to run their 401(k) plan, including the types of investments, whether they'll match employee contributions and by how much, their vesting schedule, and whether to allow 401(k) loans.

Unlike a company pension, the 401(k) belongs to the employee, is portable, and may follow you to your next employer. Many employers match a percentage of the employee's contributions, but they are not required to. You'll choose the percentage of your income that you want allotted to your 401(k), up to a certain dollar amount for the year.

So, my employer wants to help me save for retirement.

Don't worry if you can't see your employer making the Fortune 500 list. The funds for your 401(k) go into a trust or custodial account, so your money is safe even if the company you work for goes belly up. Each company's 401(k) investment choices are dictated by the company, and each employee will choose the investment or combination of investments that they want to put their money into. Investment choices commonly include mutual funds, cash instruments such as money market funds and CDs, and the company's own stock if it is publicly traded. Larger companies tend to offer more choices in investments.

401(k) contributions are automatic, taken out of your paycheck. Once you're enrolled in the plan, you'll never have to worry about forgetting to invest for your retirement. And, you'll never have to worry about spending your money before you get a chance to invest it. You know how easy it can be to put your retirement savings on the back burner; a 401(k) can ensure that your comfortable retirement is priority #1. It's so easy to budget for an expense like retirement, when it's done for you automatically.

So, is the 401(k) better than an IRA?
There are quite a few similarities between a 401(K) and an IRA, but also significant differences. The employee's contributions are commonly made before taxes, which means that the amount you contribute will reduce your taxable income. Those contributions grow tax-deferred until you begin taking distributions at retirement, like with an IRA.

Retirement age for a 401(k) is 59 1/2, just like it is with an IRA. If you take non-qualified distributions before the age of 59 1/2, you will have to pay income tax on that amount, plus a 10% penalty, just like an IRA. The exception to that rule for the 401(k) is that an employee may begin taking distributions, without penalty, if they are 55 or older when they quit their job.

Also, traditional IRA rules state that you must begin taking distributions at 70 1/2, which is the same as for a 401(k). The exception to that rule is that you do not have to take distributions from your 401(k) at 70 1/2 if you continue to work for the same company.

I say that contributions are commonly made before taxes, because we now also have a Roth 401(k) available. The Roth 401(k) became another choice a couple of years ago, but only a small percentage of employers offer them right now. More employers will probably offer the Roth 401(k) as it gains popularity, and employees begin to request them.

The Roth 401(k) is similar to a Roth IRA in the way that contributions are made after taxes, meaning you don't get a tax break now. Your contributions will grow completely tax free, and distributions are tax-free, as long as you are 59 1/2 and have had the account for at least five years before you begin to take distributions. Use Roth IRA guidelines to determine if you would benefit from a Roth 401(k).

The 401(k) plan also differs from the IRA. First of all, the 401(k) is employer-sponsored, as I said earlier. Your employer will supply you with a list of investment choices, usually somewhere between five to twenty types of investments. You'll have to accept something that your employer offers if you want to participate in their 401(k) plan. IRAs literally have thousands of investment choices among the many mutual fund companies and brokerage houses.

Also, you can't borrow from an IRA; non-qualified distributions come with a 10% penalty, in addition to the income tax due on that distribution. But most employers allow you to borrow from your 401(k), up to $50,000 or half your account balance, whichever is less. Your 401(k) loan repayments will include principal, as well as interest. You will have up to five years to pay back the loan, or usually up to ten if the loan is used for the purchase of your home. Now, keep in mind that you'll have to pay back the loan immediately if you change jobs. Taking a loan from your 401(k) is usually not recommended by financial advisers, except in special circumstances. More on that in an upcoming article.

Also, the maximum contribution allowed for a 401(k) is currently $15,500 for 2008, not counting the employer's match. That's way more than the $5000 maximum contribution for an IRA. So, the 401(k) is extra beneficial if you'd like to sock away more retirement money than an IRA allows. Also, that $10,500 difference may be enough to push you into a higher tax bracket. So, you can dramatically reduce your taxable income, thus your final tax bill, if you've got the non-Roth version of the 401(k).

And the biggest benefit to a 401(k) is the employer-matched contributions. Even I, in my young and naive days, could see the instant gains that are apparent when my employer added a little extra to my contributions. There is no better way to maximize your gains than to maximize on your employer's offer to match contributions.

Take advantage of this free money, even if you feel you could choose better investments than your employer's options. If your employer matches your contributions by 50%, that's a guaranteed 50% immediate gain. What other investment can offer you that? You'll still come out in great shape, even if the investment itself doesn't perform so hot, thanks to the big boss.

My employer's contributions. There has to be a catch.
One thing that you should know about your employer's contributions - they may not be completely yours until you've committed some time in service. So even if they match a portion of your contribution, you may lose the portion they match if you leave the company within so many years. The funds that are yours to take with you when you leave are vested; your employer's contributions may not be fully vested until you've been with them for so long.

For example, their vesting schedule may dictate that you'll own 20% more of their contribution every year until the fifth year of employment, at which time their contributions will be 100% yours. Or, you may have to work a full three years before any portion of their contribution is vested, but at that time it will be 100% vested. This only applies to the company's match, not what you put in yourself. Your personal contributions are always 100% vested, meaning it's always going to be your money.

Be sure you understand your employer's vesting schedule, especially if you think you may move on to another job within a few years. It may be worth hanging around until your employer's contributions are 100% vested.

A 401(k) sounds great, but I'm my own employer.
I earlier mentioned that a 401(k) must be employer-sponsored. What if you're self-employed? Well, good news! Self-employed folks, with no employees, can now set up their own 401(k). Known as the Solo 401(k), or individual 401(k), it is geared towards owners of sole proprietorships, partnerships, LLCs, and corporations. Business partners and spouses may also be included in your Solo 401(k), but no one else. If you plan on growing your business and hiring employees, you'll need to consider other options. But all in all, the Solo 401(k) is a great, new and improved choice over other self-employed retirement plan options. Check with your bank or mutual fund company to see if they offer the Solo 401(k).




Sources:
irs.gov
money.howstuffworks.com
chancefavors.com