Your Finish Rich Plan - A Personal Finance Blog

Seven Common 401k Questions Answered

I talked about the main benefit of a 401k in a previous post. Today I’m going to answer seven common questions about them, based on visitor feedback. Enjoy!

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1. What is the maximum amount one can put in a 401 k per year?

401k limits change every year. The 401k rules that determine your 401k maximum contribution limit — the combined total maximum contribution that you can make each year to ALL 401k plans in which you participate, including standard 401k plans and Roth 401k plans — is the lower of: (1) the maximum percentage contribution limit allowed under each of your employers’ plans, or (2) the dollar limits shown below. For example, if your employer’s 401k plan allows you to contribute up to a maximum of 10% of your salary, and you earn $50,000, your maximum contribution limit is $5,000. However an employee who earns $200,000 a year would not be eligible to max out at 10% ($20,000) because the 2007 401k contribution limit imposed by the government is $15,500.

Catch-Up 401k Contribution Limits

If you are age 50 or older, you may also be eligible to make “catch-up 401k contributions” in addition to your regular 401k limits — IF your employer allows them. (Unfortunately, your employer is not required to do so.) 401k catch-up contributions are limited each year to an additional $5,000.

The above 401k limits apply regardless of whether you participate in just one 401k plan, or if you participate in two or more 401k plans (such as a Roth 401k and a traditional 401k plan). Once again, your combined contributions to ALL plans cannot exceed the above 401k limits.

The matching contributions made your employer are NOT counted toward your 401k contribution limits. Even if you contribute the maximum amount each year, your employer’s matching contributions are in addition to these 401k limits. (FYI: Depending on the design of its 401k plan, a employer can match up to and including 6% of your pre-tax compensation.)

2. When can a 401k be garnished?

The 401(k) plan is protected by pension laws since it is a personal investment plan. It includes protection from garnishment by creditors but not from domestic cases that include child support.

3. Can contributing to a 401k help on taxes?

Let’s do the math to see the advantage of pre-tax saving. For example, you may decide you want to put $200 into your account each month. Assume that, prior to starting your 401(k), you were bringing home $2,000 per month pre-tax, and $1,440 post-tax (paying $560 in tax for a 28-percent tax bracket). Because the $200 comes out pre-tax, that means you are taxed on $1,800 (paying $504 in tax), so your post-tax income is $1,296. In other words, you are paying $200 into your 401(k), but your take-home pay only goes down by $144. You just saved $56 per month!

4. How secure are 401k investments?

Your 401(k) is not an investment. Neither is your IRA. Those are legal compartments for holding investments. Your investments are the mutual funds, stocks, bonds, and so on that you’ve bought. The compartments are where you keep your investments. So your 401k is only as safe as the investments that it’s comprised of, simple as that.

5. How can a company match help my retirement?

Although they aren’t required to, many employers match a percentage of what their employees contribute to their 401(k) accounts. The catch is, they typically don’t put anything in unless you do. Your employer is not required to make any contribution to your plan at all. So, why pass on its generosity if it does offer one?

Going back to the previous example, suppose your employer kicks in an additional 50 cents for every dollar you contribute. (That’s a fairly common match.) Your $200 contribution is now worth $300.

Between the tax savings and match, saving $200 in your 401k plan gives you an extra $156 to put toward your future that you wouldn’t have had if you took the dollar as income and spent it today.

Down the road, getting a match does make it easier to have a nice retirement.

6. Are there limits to employer matching?

Plans set up under section 401(k) can also have employer contributions that (when added to the employee contributions) cannot exceed other regulatory limits. The total amount that can be contributed between employee and employer contributions is the section 415 limit, which is the lesser of 100% of the employee’s compensation or $45,000 for 2007, and $46,000 for 2008.

7. Can I leave my money in my 401k plan after I retire?

You CAN, but SHOULDN’T. For three reasons:

Fiduciary responsibility limits investment choices. Congress requires business owners and officers to make sure their retirement plans are run for the benefit of the employees. This makes them fiduciaries, which means they have a legal obligation to select prudent investment choices for the retirement plan. This law, known as ERISA (the Employees Retirement Income Security Act), means owners and officers could be subject to unlimited personal liability if they don’t fulfill their obligations. Therefore, most plans limit the number of investment choices they offer employees to no more than eight to 12.

You needed growth while you were working, but you need income after retirement. If you look carefully, you’ll find that most of the investment choices in retirement plans are usually geared toward growth, not income. They’re chosen because that’s what the employees and owners want. Little thought is given to income-generating investments.

Expenses can be higher than you realize. While most people believe that 401(k) plans are “cheap” because you’re getting a group deal, that’s not necessarily true.

The fact is, when you retire, you will have to convert your retirement plan into an ongoing income stream so you can have the money to do what you want, when you want. You can put your money in a savings vehicle that enables you to generate an attractive retirement income, but in order to do so, you must have investment choices that aren’t in most 401(k) plans. If you rollover your 401(k) to your own self-directed IRA, then you can enjoy a whole new world of investment options, including everything you need to convert your retirement plan into an income stream.

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