Finish Rich: Your Lowly 401k Can Help!
The aging of the population and the potential failing of social security has brought the subject of saving for retirement to the forefront for many people: the responsibility for a financially secure retirement now falls squarely on your shoulders. There are many ways to build the nest egg that you will need to survive on during your golden years. IRA’s, mutual funds, annuities and 401(k)’s are just some of the options to research as we prepare for our future.
With all of these choices, the 401(k) is the most popular. Whether your retirement is decades in the future or only a few years away, you should start planning now to insure that your retirement is spent pursuing your hobbies rather than living from one Social Security check to the next. However, if you do not handle it properly, your 401k plan can be a losing proposition. Here are a few tips to insure your 401k plan helps you have the retirement of your dreams.
WHAT’S A 401K
A 401(k) account is a tax deferred retirement account. In plain English, that means you contribute money directly from your paycheck to your 401(k) account. Because you never “touched” the money, you do not pay taxes on those earnings. It’s really simple: you sign a contract and your employer deducts a certain percentage of your income (before taxes) that gets tucked away for your retirement. You will receive this money at age 59 1/2 or after you retire, by which time it has hopefully vested interest and has had an employer contribution.
ADVANTAGES OF A 401K
Tax advantage
Money is deducted from your paycheck on a pre-tax basis, which means it reduces your taxable income. For example, if you have a monthly income of $1,000 and contribute 10% of that to your 401(k), then you will only pay taxes on the $900 you physically receive. Furthermore, all contributions from employers and any growth in the capital itself experience tax-free growth until withdrawal.
Effect of compounding
The compounding effect of consistent contributions over the period of 20 or 30 years is very significant. A previous post has covered the power of compounding.
Employer match programs
If your company matches your contributions, it’s like getting extra money on top of your salary. Many employers will match an employee’s 401(k) contribution, up to a certain amount. Essentially what that boils down to is an automatic return on your investment.
Under our previous example, you contributed 10% of your $1,000 salary every month. Let’s say your employer matches every $1 of your contribution with a $0.50 contribution of their own. That means each month when you put in $100 your employer will put another $50 in your account for you. That’s an instant return of 50%! Granted, this is just an example, and not every company will match this well, but no matter what your company matches, the moral of the story is that it is an automatic return on your investment, and you’d be a fool to pass up this free money - which could eventually mean hundreds of thousands of dollars towards retirement.
Protection of pension laws
This means that your 401K contributions are protected against garnishment from people you owe money to. There is one exception, however, and that is child support.
Control
You decide where to direct your future contributions and/or current savings, giving you substantial control over the investments.
DISADVANTAGES OF A 401K
Expensive to withdraw money prior to age 59 ½.
Unless it’s a matter of life or death, do not fall in to the temptation of taking money from your 401k retirement fund before you’ve retired. You will pay for early withdrawal including a penalty (usually 10%) and income tax on the money you take out of the account. There are a few exceptions that will allow the penalty (but not the tax) to be waived.
Vesting periods
Employer matching contributions are usually not vested (i.e., do not become the property of the employee) until a number of years have passed. The rules say that employer matching contributions must vest according to one of two schedules, either a 3-year “cliff” plan (100% after 3 years) or a 6-year “graded” plan (20% per year in years 2 through 6).
In plain English, under the 3 year cliff plan, the employer contributions only become yours after 3 years; if you leave the company before that, you only keep your personal contributions. After the 3 year period, though, the whole amount is yours to keep. Under the graded plan, every year, 20% of what your employer has contributed becomes yours, starting at year 2.
HOW DO YOU TAKE ADVANTAGE OF IT?
Usually you are allowed to choose from a variety of mutual funds in which you can invest the contributions made to your 401K plan. Typically you may choose from a low risk, medium risk or high risk and allocate a certain percentage to one or all of these funds. That money can be allocated to stock, bonds, mutual funds and/or money market accounts; it all depends on the company your employer uses. You are allowed to change your investment percentages and deductions at certain times of the year.
Keep in mind, though, that there are limits to how much you can contribute to a 401k. The pre-tax contribution limits set by the IRS for 2008 are:
- $15,500 per year for those under 50 years of age
- $15,500 per year plus $5,000 additional catch up contribution for those over 50 years of age
To maximize your 401(k), you should definitely try to contribute the maximum amount you are allowed each year.
FINISH RICH RECOMMENDATIONS
401k Rollover
Never cash out your 401k when you are changing your job. Statistics show that nearly 90 percent of people end up cashing out their 401k when they change their jobs. If you do it, you are wasting a lot of your hard earned money. First have to pay early withdrawal fees (usually 10%) and then taxes on that amount. In the bargain you end up losing nearly 40% of your money. To top it off, this is money that won’t be compounding and padding your retirement nest egg.
If you feel uncomfortable leaving your savings in the care of your ex-employer, or if your company charges a fee for leaving your account with them, you should roll over the 401K money from the previous employer’s account to the new one. The accounting departments of the companies generally manage this. An advantage is that the accounting staff takes care of all the paperwork, which could be tedious for one who does not understand the formalities required.
401k Allocation
If you aren’t sure how your 401k should be invested, a 401k subscription could be right for you. A good 401k subscription provider will help you keep your 401k allocated properly, according to the current market conditions, your age, and retirement goals. Just make sure it fits your risk profile. One cardinal rule, though, is that should not invest a large portion of you 401k in your employer’s company (or your own). Enron employees, who invested primarily in Enron stock, lost the value of their 401k retirement plans when Enron stock plummeted.
401k Annual Checkup
First, you should evaluate your contribution amount. For example, receiving a raise at work is a great occasion to increase your retirement contribution. Next, you should take a look at your investment choices and make sure you’re not holding on to poorly performing investments. Finally, you should check on the way your investment options within your 401(k) are spread. Since financial experts sometimes advise that retirement accounts should be spread among many different types of investment, you may want to re-balance your account on a regular basis.
You can indeed get the best out of your 401k if you make wise investment choices and build your portfolio carefully.
April 24th, 2008 at 2:33 am
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May 8th, 2008 at 5:26 am
[...] buy your next car or house. Of course, every financial plan should include a strategy to help you save for retirement. Making a financial plan is best done in [...]
July 3rd, 2008 at 2:06 pm
When cashing out my 401k, “… this is money that won’t be compounding and padding your retirement nest egg.” Don’t you mean padding and compounding my employers and his brokers accounts? Get real. I do not have one of these scam 401ks and I never will. I have no interest in making rich people richer.
July 9th, 2008 at 6:22 am
Robert, you are certainly entitled to your opinion. Unfortunately, the jury is pretty much IN on this one. Not having a 401k is not a good financial move. And just so you know, your 401K costs your employer money, because not only does he have to pay management fees, but on top of that many employers match your contributions up to a certain point. Of course leaving money on the table AND missing on the power of compounding is entirely up to you!