A 401(k) plan is a retirement savings plan that many United States employers offer to its employees. In this plan, participates contribute pre-tax salary into the plan and is often rewarded with a match for a portion of the contribution.
Congress recognized that corporations have been cutting back on its pension packages to remain competitive globally. So under the Revenue Act of 1978, Congress added section 401(k) and stated that employees are not taxed on the portion of income they elect to receive as deferred compensation rather than as direct cash payments.
Pros and Cons of 401(k) Plans
There are many advantages of 401k plans, which I list a few here:
- Contribution are pre-taxed
- All earnings and income from investments can grow tax-free
- Employees get to pick their own investments (self-directed). Therefore, you can pick your favorite mutual fund investment
- Many companies match your contribution to a certain percentage, effectively giving you a raise.
- You can change jobs and the 401k moves with you, unlike pension.
- While the money is essentially yours, it’s very costly to access 401k money before the age of 59 1/2.
- Since it is pre-tax dollars in the account, withdraws are subject to taxes. With the uncertainty of future tax rules, it’s hard to really know how much money is really yours.
- The tax complications make financial planning much harder if you have both post-tax accounts and pre-tax accounts as you can only guess future tax rates.
- The plan is self-directed.
Notice that the plan being self-directed is both an advantage and a disadvantage. In theory, having more control is always good but as we know from history, investors do not always invest logically.
Many employers’ 401(k) plans are actually offered through payroll or investment companies like ADP or Fidelity. These third parties will often work with your employer’s plan administrator to come up with a list of investment choices for all its employees.
One thing to note is that while third party companies might have hundreds of investment choices, the list available to employees are usually narrowed to 10-20. The idea is usually that if there are too many choices, it makes administration impossible and also becomes too confusing for most employees.
While the choices are limited and is based on the discretion of the employer, the majority of 401(k) plans offer investment choices that are diversified, including:
- Money Market Funds
- Bond Funds (short, intermediate, and long term)
- Various Stock Funds
- Index Funds
- Company Stock (if applicable)
In order to keep taxes coming, the IRS limits plan contributions to a fixed amount each year. The limits are said to be inflation indexed (as an example, limits from 2005 – 2009 are listed below)
- 2005 – $14,000
- 2006 – $15,000
- 2007 – $15,500
- 2008 – $15,500
- 2009 – $16,500
To help people closer to retirements save for the future, the IRS included a “catch-up” limit for people ages 50 and above. These limits are higher and the limits from 2005 – 2009 are:
- 2005 – $18,000
- 2006 – $20,000
- 2007 – $20,500
- 2008 – $20,500
- 2009 – $22,000
Note that these are participates contribution limits. This means that the limit do not include the matching contributions of the employer, nor the capital gains that any portfolio can have.
Penalties of Early Withdrawal
To limit participates from withdrawing money early (401(k) plans are meant to be “retirement” funds after all), there are steep penalties for withdrawing money early from the retirement plan. In general, the penalty is 10% off the withdraw amount on top of the withdrawal being subject to taxes. Therefore, think extremely thoroughly before taking out money from your 401(k) plan.
There are also penalties for not withdrawing. A participant who is of age 70 and a half years old must start taking minimum withdraws or face monetary penalties. The only way around this is if you still work after 70 and a half and your 401k still being with that employer, then you don’t have to take the annual minimum withdraw.
If you really need money from your 401(k), not all is lost though. There is a way to retrieve funds from your 401(k) plan without penalty, and that’s through a loan from your plan. Essentially, you are taking a loan from yourself, so money (principle and interest) are paid back to yourself. The major disadvantage is that if you lose your job, all the money will need to be paid back immediately (not a good thing)!
Even without a loan, those who leave their job after the age of 55 can start withdrawing without penalty, even if they are working through another job.
Companies can elect to match part of your contributions. For example, your employer may match half of the first 6% of your salary if they are 401(k) contribution. Say your salary is $100,000 and contribution 6% of your salary ($6,000), then the employer will add another $3,000 to your 401(k) plan. This is one of the major advantages of contributing to a 401(k) plan, because it is like electing to get a raise.
Changing / Leaving Your Job
If you are switching to a new job, remember to ask your new employer if you can directly roll-over your 401(k) plan to the new company. Other options include:
- Withdrawing the money (not recommended)
- Opening a Traditional IRA and rolling it over
- Leaving It with Your Old Employer (not always available)
For the most part, rolling it over to a tradional IRA is generally the best option because companies offering IRA accounts usually offer more investment choices. However, many people like to roll it over to the new employer because of ease of administration.
Take caution because the check from your old employer must be made in the new employer’s plan name if it’s a roll-over. If it’s made to you, a mandatory 20% penalty must be withheld so you will have to come up with the missing 20% contribution for the new plan within 60 days to make up the difference. Otherwise, it is treated as a withdrawal and the 10% withdrawl penalty applies.
Should I Contribute?
While the government heavily encourages contribution to 401(k) retirement plans, many people do not participate because either:
- They are lazy.
- They don’t see the benefit.
In general, experts believe that everyone should at least contribute to the extent to take advantage of the employer contribution match. As whether to contribute further, it will depend on individual circumstances.
More Information 401k Retirement Plans
With its name coming from a subsection in the U.S. tax code, the 401(K) is a well known type of retirement savings account offered by many companies as part of their benefits package. Presented as an alternative to the traditional employee funded pension, the 401(K) moved a significant portion of the responsibility for retirement funds from the employer to the employee.
In a recent survey it was found that 60% of American households nearing the age of retirement had at least some form of 401(K). Unfortunately, a majority of those accounts will not be sufficient to support retirees over the long term. In fact, only about 25% of retirees can expect to maintain their standard of living based upon these savings.
How much the employer contributes to the account varies tremendously. In good financial times employers may match the employee contribution dollar for dollar, but in poor conditions, they may contribute nothing.
The reason that 401(k) plans are so popular is that they are much cheaper for employers to maintain. The employer only has to pay for administration and support costs, and even some of those can be passed on to employees. Furthermore, employers can anticipate exactly what those costs will be each year, making it easier to manage a budget.
For a 401(k) to be a successful vehicle for retirement savings individuals should contribute the maximum amount allowed annually, diversify their contributions and avoid any unnecessary withdrawals before the age of 59 ½ . Early withdrawals of funds are accompanied by severe financial penalties.
Wise investors will also make contributions to other retirement accounts, post tax, in order to increase their chances of having sufficient resources to enjoy a consistent standard of living in their later years.