Investing Options Series: 401(k)

Posted on 21. Jul, 2006 by in Saving & Investing

I’m continuing the investing options series by covering long-term investing options – starting with 401(k)s.

What Are They?
A section 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pre–tax basis. You may then withdraw your contributions after you turn 59 ½ without any penalty to use on enjoying your retirement.

401(k) accounts are considered such a great retirement investment account because the wages you “defer” into your 401(k) account are not subject to income taxes – meaning you don’t have to report your contributions on your Form 1040 (PDF) since they were not included in the taxable wages on your Form W-2 (PDF). However, they are included as wages subject to social security, Medicare, and federal unemployment taxes. In a nutshell, 401(k)s are so great because they let you increase your take home pay and decrease your current taxable income. Remember though, your pre-tax contributions are not tax-free, they’re tax-deferred.

Even the interest and capital gains that are earned during the life of your 401(k) is earned “tax-free.” But when you finally do withdraw your cash (after you turn 59 ½ years old) you are taxed at normal rates. The thought behind this plan is that once you have retired your marginal tax rate will be lower than it was while you were earning your salary.

Different Flavors
There are three basic types of Money Market Accounts according to Bankrate.com:

  • The basic account often requires a minimum opening deposit of $100.
  • The tiered account often requires a bigger minimum opening deposit than a basic account but pays a higher yield as deposits increase. For instance, an account holder might earn 2 percent interest with a $500 balance, but as much as 5 percent interest or more with a balance of $50,000.
  • The package deal offers a money market account in conjunction with savings, certificates of deposits and other bank investments. Banks and credit unions may offer a slightly higher yield to holders of these accounts than to basic- or tiered-account holders. Because this is a package deal, a minimum deposit may be waived.

Short or Long-Term Investment?
When talking about 401(k)s we’re talking about saving for retirement, so the purpose of investing in a 401(k) is definitely long term in nature. Although contributions can usually be made at any time during your life, the purpose behind a 401(k) account is to start early to build a nest egg during your working years.

Potential Risk
The biggest risk with a 401(k) account is the penalties associated with early withdrawal. By law, withdrawals will be taxed as ordinary income and may also be subject to a 10 percent early withdrawal penalty if taken before age 59 1/2. There are a few instances, however, when you may not have to pay this early withdrawal penalty including:

  • Certain medical expenses for you, your spouse or your dependents
  • Purchase of a primary residence (excluding mortgage payment)
  • Payments of certain post-secondary education expenses for the next year for you, your spouse or your dependents
  • To prevent eviction from or foreclosure on your primary home

Potential Return
Unlike other retirement plans, the potential return is mostly up to you. In trustee-directed 401(k) plans, the employer appoints trustees who decide how the plan’s assets will be invested. However, in the more common participant-directed plans, the employee can select from a number of investment options including an assortment of mutual funds that emphasize stocks, bonds, and money market investments, or some mix of the above. Many companies’ 401(k) plans also offer the option to purchase the company’s stock. As you may begin to see, the potential return on your 401(k) depends in large part on the stocks, bonds, or mutual funds you choose to invest in.

Many employers offer 401(k) matching programs, giving you an almost guaranteed return. For example, many employers will offer to match your contributions at $.50 on the dollar up to 8% of your salary. So for each dollar you invest at that employer, you’re making a 50% return up front! Try getting that from the stock market. If your employer offers a matching program I would highly recommend participating – at least until reaching your employer’s matching limit. After all, who wants to turn down free money?
You should be aware, however, that some companies have vesting schedules for employer contributions. This means you may have to work a certain amount of time to keep the money the company contributes (An example would be after 1 year, you get 20%, after 2 you get 40% and so on).

To get an idea of the potential return from a 401(k) account – compared to some other savings plan – take a look at the graphic below, courtesy of Fidelity. This outlines the potential difference in take home pay by deferring your income into a 401(k) plan instead of setting aside into another type of savings plan.

401(k)savings.jpg

Limits
It’s important to realize that there are maximum limits to the amount you contribute as an employee and the amount your employer can contribute to your 401(k) plan. The employee limit, known as the “402(g) limit”, is $15,000 for the year 2006 and will be adjusted for cost of living increases every year. However, employees who are 50 years old or over at any time during the year are now allowed additional pre-tax “catch up” contributions of up to an additional $5,000 for 2006. (IRS link to limits here)

Employer contributions are maximized according to the combined amount of employee and employer contributions. The total amount that can be contributed between employee and employer contributions, known as the section 415 limit, is the lesser of 100% of the employee’s compensation or $44,000 for 2006.

It is important to note, however, that employers can choose their own maximum limits. For example, your employer could enforce a 10% contribution limit which means a person with a salary of $50,000 effectively has a contribution limit of $5,000 even though the government limit is higher. So check with your employer before trying to maximize your contribution.

Balancing Your Investment
Since you’re the one primarily in charge of your 401(k) investment, it is in your best interest to diversify your 401(k) portfolio just as you would any other investments. Even if your firm is good enough to offer mutual funds as part of your 401(k), you should still avoid putting all your money into one fund. Diversify, diversify, diversify. The way you do this is completely up to you, but there are some fairly good guidelines out there such as this one from Money Magazine:

Aggressive–for those with 35 or more years until retirement

  • 50%–large cap stocks
  • 15%–mid cap stocks
  • 15%–bonds
  • 10%–small cap stocks
  • 10%–international stocks

Moderate–for those with 20 years until retirement

  • 35%–large cap stocks
  • 35%–bonds
  • 10%–mid cap stocks
  • 10%–small cap stocks
  • 10%–international stocks

Conservative–for those within 10 years of retirement

  • 40%–bonds
  • 30%–large cap stocks
  • 10%–mid cap stocks
  • 10%–international stocks
  • 10%–cash

Who is this a Good Investment For?
Anyone who wants to save for retirement! 401(k)s used to be available only to those who were working for a medium to large-sized company; however, new 401(k) plans are available to small businesses and even self proprietors – known as Solo 401(k) or Individual 401(k) plans. You can find a bit more information about these plans here or here.

Basically, this investment option is a wise choice for anyone – especially for those who have employee matching programs at work. And since Social Security benefits won’t be around by the time I retire, 401(k)s are a great alternative.

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  1. Pierres Service » Blog Archive » investing options series: 401(k) - November 29, 2006

    […] investing options series: 401(k) you should be aware, however, that some companies have vesting schedules for employer contributions. this means you may have to work a certain amount of time to keep the money the company contributes (an example would be after 1 year, …Read more: here […]

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