401(k) Q & A
Q. What is a 401(k)
A 401(k) plan is a tax-deferred investment and savings plan that acts as a personal pension fund for employees. It allows employees of corporations and private companies to save and invest for their own retirement. In a 401(k) plan, you authorize pre-tax payroll deductions to be invested in mutual funds or other investment options offered by your company's plan. Both the contributions and the investment earnings can grow tax-deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income.
401(k)s were established by the federal government in 1981 to encourage workers to establish retirement savings plans. The name refers to the relevant section in the Internal Revenue Code.
A 401(k) is a fairly simple plan. It is set up by your employer as a set contribution retirement agreement. That means you are the one who pays into the plan, although your employer and the plan provider who offers your 401(k) do just about all the work.
Your 401(k) contribution is automatically deducted from your paycheck each pay period. This money is taken out and invested before your paycheck is taxed. After you have decided what percentage you want deducted from your check, and how you want to invest it, your work is pretty much done.
Once the money is deducted from your paycheck, you can't spend it, but it is yours. It grows in your personal 401(k) account. Although you can withdraw the money for certain emergencies or in some cases borrow against your investment, the money is intended to stay in your account until you are at least 59 1/2.
While the investment is growing in your 401(k) account, you do not pay any taxes on it. When you withdraw the money at retirement, you pay taxes on the amount you withdraw from your account (so you pay taxes little by little instead of being hit with one big bill).
And in some cases, your employer makes their own contributions to your 401(k) plan. This is an option for your employer and they are not required to make a contribution. If they do chose to make a contribution, it takes the form of an employer match on your contribution. Usually the employer matches a certain percentage of your contribution. For example, an employer may elect to put in 50 cents for every dollar you contribute. That's an immediate return on your contribution, regardless of how you invest your 401(k) money. This contribution can be anywhere from a small percentage to an exact match of your contributions.
Q. What are the advantages to a 401(k) plan?
There are many advantages to 401(k) plans.
- The employee is able to contribute to his/her 401(k) with pre-tax money, it reduces the amount of tax they pay out of each pay check.
- All employer contributions and any growth in the investment is able to be tax-free until withdrawal.
- The employee can decide where to invest future contributions and/or current savings, giving much control over the investments to the employee.
- If your company matches your contributions, it's like getting extra money on top of your salary.
- Unlike a pension, all contributions can be moved from one company's plan to the next company's plan, or a special IRA, should a participant change jobs.
- Because the program is a personal investment program for your retirement, it is protected by pension (ERISA) laws, which means that the benefits may not be used as security for loans outside the program. This includes the additional protection of the funds from garnishment or attachment by creditors or assigned to anyone else, except in the case of domestic relations court cases dealing with divorce decree or child support orders (QDROs; i.e., qualified domestic relations orders).
- While the 401(k) is similar in nature to an IRA, an IRA won't enjoy any matching company contributions, and personal IRA contributions are subject to much lower limits.
Q. What are the disadvantages to a 401(k)?
There are, of course, a few disadvantages associated with 401(k) plans:
- It is difficult (or at least expensive) to access your 401(k) savings before age 59 1/2.
- 401(k) plans don't have the luxury of being insured by the Pension Benefit Guaranty Corporation (PBGC). (But then again, some pensions don't enjoy this luxury either.)
- Employer contributions are usually not vested (i.e., do not become the property of the employee) until a number of years have passed.
- Each year, the Internal Revenue Service sets a maximum contribution limit for 401(k) accounts. For the 2000 tax year, the employee contribution limit is $10,500.
Q. What are some of the investment options for my 401(k)?
Participants in a 401(k) plan generally have a decent number of different investment options, nearly all cases a menu of mutual funds. These funds usually include a money market, bond funds of varying maturities (short, intermediate, long term), company stock, mutual fund, US Series EE Savings Bonds, and others. The employee chooses how to invest the savings and is typically allowed to change where current savings are invested and/or where future contributions will go a specific number of times a year. This may be quarterly, bi-monthly, or some similar time period. The employee is also typically allowed to stop contributions at any time.
With respect to participant's choice of investments, expert (sic) opinions from financial advisors typically say that the average 401(k) participant is not aggressive enough with their investment options. Historically, stocks have outperformed all other forms of investment and will probably continue to do so. Since the investment period of 401(k) savings is relatively long - 20 to 40 years - this will minimize the daily fluctuations of the market and allow a "buy and hold" strategy to pay off. As you near retirement, you might want to switch your investments to more conservative funds to preserve their value.