401k Plans

A 401(k) plan (named after a section of the tax code) is a Federally approved plan established by your employer that lets you set aside a percentage of your pay before taxes are taken out. Any growth in the 401(k) is tax-deferred. Similar to an Individual Retirement Account (IRA), a 401(k) is designed primarily as a retirement 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 pay, which varies based on your employer's plan. The Federal government establishes the maximum dollar amount of an annual contribution. See the chart below.

There are several substantial benefits to 401(k) plans that can make them a valuable part of your overall retirement plan:

Any earnings on your 401(k) account grow tax-deferred. Since earnings are not taxed until they are withdrawn, you have more real dollars working for you. With taxes on earnings deferred, your account balance may grow more quickly.

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which means you do not pay Federal (or most state) income tax on your contributions to the plan until the money is withdrawn, typically at retirement.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.

Automatic payroll deductions make saving for retirement easy. You're less likely to miss money you never see.

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.

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 591/2 will mean you will pay taxes on the withdrawal and generally are assessed an early-withdrawal penalty of 10%.

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.

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.

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.

Usually you are eligible to join a 401(k) plan if you:

are an eligible employee of a company that offers such a plan.
are over the age of 21.
have worked for the company for a certain period of time (not to exceed 1 year).

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). 

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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 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 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 & 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:

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.

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.

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.

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.

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.
 

Conservative or Low-Risk Investor:

I don't want to risk any of my principal.
I want a guaranteed rate of interest on my investment.
I am near retirement.
 

Moderate or Medium-Risk Investor:

I can live with some ups and downs.
I would like a combination of high- and low-risk investments.
I have some time for my money to grow.

Aggressive or High-Risk Investor:

I have an iron stomach and can handle market swings.
I want the highest possible long-term rate of return, even if I risk losing short-term principal.
I have at least 10-15 years for my investments to grow.
 

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.

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.
You may be able to withdraw the money. If you are over 591/2, and you take your money in a lump sum, you. ll pay ordinary income tax on the amount. If you are under 591/2, and take your money in a lump sum, you. ll generally pay regular taxes plus a 10% tax penalty.

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.

Directly transfer the money to an IRA rollover. 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 an IRA. Again, make sure the transfer of money goes directly from institution to institution to avoid having taxes withheld.

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. If you are looking for unsecured personal loans then this company can help you secure a loan with good or bad credit.

Many plans also permit hardship withdrawals, usually for the purchase of a primary residence, payment of college tuition, payment of medical expenses or to prevent the eviction from or foreclosure of your principal residence. Depending on your employer's plan, qualified hardship withdrawals are subject to a 10% Federal income tax withholding in addition to regular income tax and a 10% early withdrawal penalty. If your plan so provides, you also can withdraw money without being penalized if you are medically disabled as defined by the IRS. Your plan may not allow you to make additional contributions for a period of time after a hardship withdrawal.

Other withdrawals taken before the age of 591/2 (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 701/2. Such distributions must begin by April 1 of the calendar year following the calendar year in which you reach age 701/2 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 701/2 while you are still working. Other plans may allow you to choose to begin distributions at age 701/2 or defer the commencement of your distributions until you retire.

This website provides only a general overview of estate planning. You should consult an attorney, or perhaps a CPA or tax advisor for additional guidance.

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