401(k) Plans
This collection of personal financial information is directed to works for a
living. Everyone needs to know more about financial matters. The SOURCE
for much of this information is the GSA Consumer Information Catalog published
by the Federal Citizen Information Center.
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 pre
retirement 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any growth in the 401(k) is tax-deferred until withdrawn.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.
5
Year
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Contribution
Limit
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2002
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$11,000
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2003
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$12,000
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2004
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$13,000
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2005
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$14,000
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2006
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$15,000
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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:
Year
|
Catch-up
Contribution Limit
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2002
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$1,000
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2003
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$2,000
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2004
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$3,000
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2005
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$4,000
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2006
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$5,000
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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:
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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.
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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.
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Automatic payroll deductions make saving for
retirement easy. You’re less likely to miss money you never see.
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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.
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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%.
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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.
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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.
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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.
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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:
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are an eligible employee of a company that offers
such a plan.
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are over the age of 21.
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have worked for the company for a certain period of
time (not to exceed 1 year).
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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:
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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.
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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.
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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.
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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.
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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.
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Conservative or Low-Risk Investor:
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I don’t want to risk any of my principal.
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I want a guaranteed rate of interest on my
investment.
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I am near retirement.
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Moderate or Medium-Risk Investor:
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I can live with some ups and downs.
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I would like a combination of high- and low-risk
investments.
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I have some time for my money to grow.
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Aggressive or High-Risk Investor:
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I have an iron stomach and can handle market swings.
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I want the highest possible long-term rate of return,
even if I risk losing short-term principal.
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I have at least 10-15 years for my investments to
grow.
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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.
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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.
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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.
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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.
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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.
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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:
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What is the maximum amount/percentage you can
contribute?
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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?
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How many years of company service are required before
you are fully vested in your employer’s contributions to your 401(k)?
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How often can you transfer money between the
investment options in your plan?
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When are earnings on contributions credited to your
account—daily, monthly, quarterly? Earnings on contributions that are
posted more frequently generally compound faster.
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How often are account balance statements provided?
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How can you access your account? Can you get updates
or make transfers via computer, phone or written correspondence?
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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.
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Have you sought financial advice? You may want to
consult a financial advisor, attorney, accountant or tax advisor about your
family’s future needs.
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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.
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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.
Here are books which are available directly from Amazon.com
that may be of interest to you. Click on the title to go directly to Amazon
where you can order with a credit card or debit card.
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