What is a 401k?
A 401(k) plan is a company-sponsored qualified retirement plan for employees. Contributions and earnings in a 401(k) plan are not subject to federal and most state income taxes until the funds are withdrawn. A 401(k) plan allows you to save money on a pretax basis, and most employers will contribute matching funds to make the 401 (k) plan even more lucrative. Usually you will have the option to decide how much you contribute (up to the maximum allowed by the government) and where you will invest your contributions (from a list of funds provided by your plan sponsor).
If you are over the age of 50, there is a catch-up amount you can invest in addition to the maximum for each year.
Your contributions will be deducted from your paycheck before taxes are withheld. Depending on your tax bracket, this pretax deduction can be like getting a 25 percent rate of return on your investment. You’ll eventually have to pay taxes on the money but you should be in a lower tax bracket when that time comes. These contributions are then invested into the funds you select. Most plans offer stock, bond, and money market funds.
If you’re lucky enough to work for a company that provides the benefit of a company match, it’s like earning free money. Enroll in your employer’s 401(k) plan, and then contribute enough to earn your employer’s maximum matching 401(k) contribution. Like I said, it’s free money!
Before your 401(k) plan money earns the first dollar of interest, you’ve already had a 100 percent growth if your employer matches you dollar-for-dollar. Even if the match is only 50 cents on the dollar, that’s still an instant 50 percent growth, guaranteed! You can’t get that kind of growth anywhere else.
Each company has a vesting schedule, and it is to your benefit to understand exactly when you will become vested. The vesting schedule outlines how much of the company matching contributions and earnings on those contributions you own at any given time. If you leave the company before you are fully vested, you will lose some of the money in your plan.
Withdrawing Money from a 401(k)
Currently, the law requires that you begin withdrawing money from your 401(k) plan by the age of 70 ½. You can defer this withdrawal rule if you are still a full time employee with the company sponsoring your 401k.
You may begin withdrawals at age 59½ without any early withdrawal penalty. You are also exempt from this penalty if you are over age 55 and have been let go by your company or if you become totally disabled.
About 85 percent of 401(k) plans allow employees to take loans against the money in their account, up to a maximum of 50 percent of their savings. The money you borrow is not subject to the 10 percent penalty as long as you pay it back (with interest) within the time established by your employer’s plan.
You would have up to 5 years to repay the loan, but if you leave your job, it must be repaid within 30 days. Any amount that you fail to repay is subject to the 10 percent early withdrawal penalty and taxes. And the interest? The interest you pay goes directly into your account—you are paying it to yourself!
Investing in your own retirement is a no-lose proposition, and 401(k) plans are an easy-to-understand and convenient way to do it. Once you have started participating in a 401(k) plan, you should rebalance your investments on a regular basis. Most companies will have a yearly open enrollment period at which time you can discuss your retirement goals with the plan sponsor. Once your have reassessed your goals and your risk factor, you can look at your investments to be sure you have the correct balance.
How should a 401k be balanced?
According to Money magazine, the suggested allocations at three life stages are:
Aggressive–for those with 35 or more years until retirement
50%–large cap stocks
15%–mid cap stocks
10%–small cap stocks
Moderate–for those with 20 years until retirement
35%–large cap stocks
10%–mid cap stocks
10%–small cap stocks
Conservative–for those within 10 years of retirement
30%–large cap stocks
10%–mid cap stocks
A 401(k) plan is an important part of retirement planning. You should learn everything you can from your employer about the plan that is offered. Gather information on such things as vesting, contribution limits, and matching funds. Research all available information on the funds offered for investing. Track your investments regularly and ask for assistance if you feel your investment options aren’t performing satisfactorily.