Many Americans today are living longer, healthier lives which could mean additional retirement years for which you MAY have to provide an income. Its up to you to make yours a comfortable retirement. In most instances, Social Security alone wont provide the necessary level of preretirement take-home pay youll need once you quit working. Thats where a 401(k) comes in.
Fortunately, you may have access to a powerful retirement tool that can provide a portion of your retirement incomea 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. Heres 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 Both the employer contributions (if any) and any growth in the 401(k) is tax-deferred until withdrawn.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||Contribution Limit|
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|
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:
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 employers 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 employers contributions immediately, without waiting to be vested.
Usually you are eligible to join a 401(k) plan if you:
For full information on the rules governing your employers 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 sixtoeight options, but some offer an even broader range. Its 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 optionssome highrisk and some lowrisk. 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 options GICs and other contracts. Financial ratings of insurance companies are issued by companies such as Moodys, A.M. Best or Standard & Poors.
Company Stock. By selecting your employers stock, you acquire an ownership interest in the company. Buying the stock of any single companyincluding 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. Youll 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 & Poors and Moodys 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:
Conservative or Low-Risk Investor:
Moderate or Medium-Risk Investor:
Aggressive or High-Risk Investor:
Whatever your investment philosophy, you should never put money in an investment you dont understand. And dont 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 portableyou 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.
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 dont 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 plans 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, youll want to know the following:
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 tomorrows inflation and can help provide you with the money youll want to enjoy your retirement years.
For More Information
401(k) Take Charge of Your Future
Eric Schurenberg, Warner Books $10.95
The Complete Idiots 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.
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, thats 1-800-638-5433.
If youre on the Net, check us out. Were part of MetLife Online®.