Americans are living longer lives with better health. That’s the good news. More than that, however, it should serve as a reminder of the importance of planning for retirement. Most Americans will not be able to rely on Social Security alone to meet their financial needs in their retirement years. Having access to a 401(k) plan through an employer is a key asset to providing the needed resources for retirement.
A 401(k) is a form of retirement savings, named after a section of the Federal tax code. Its an employer-established plan similar to an Individual Retirement Account (IRA). A 401(k) plan is generally funded by an employee’s pre-tax salary contributions, frequently along with a matching contribution by the employer. The employee’s contributions, along with any matching funds and growth in the fund over time, are tax deferred until the employee reaches age 59 . Once money is in the 401(k) account, it generally cannot be removed without penalty (except for special circumstances) before the employee reaches age 59 . In many instances, however, employers include provisions for loans to be taken from an employee’s plan.
Benefits of Investing in a 401(k)
Among the benefits of investing in a 401(k) are the following:
* Under a 401(k) plan, an employee’s contribution is tax deferred; that is, the money saved cannot be taxed until it is withdrawn, adding to the overall amount.
* Because the contribution is taken from an employee’s gross income, the pre-tax amount that is contributed means that income is not subject to Federal (or most state) tax until the money is withdrawn, typically at retirement. Frequently, the retired employee is in a lower tax bracket, and as a result, will pay less tax on this income overall.
* Automatic payroll deductions make saving less apparent and likely less painful.
* Unlike pension plans, the employee has control of his or her money under a 401(k) plan, determining how it will be invested and the level of risk is controlled by the employee, not the employer.
* A 401(k) plan is portable. It can be left with an old employer, moved to a new employer, or rolled over to an IRA, even withdrawn (although at a steep tax penalty).
* Unlike most investing, a 401(k) needs no minimum to open the account, and can be built slowly over time.
* Many employers establish an accompanying 401(k) loan plan that allows employees to borrow from their 401(k) accounts (without tax or penalties in the form of a “loan to self”). This loan can be paid off via payroll deductions, and the loan interest returns to the employee as well.
* The employer may offer matching funds for any contribution by the employee.
Amount an Employee Can Contribute
Each 401(k) is set up by the individual company, and it is the company that determines the percentage of before-tax pay that may be contributed. Federal tax law limits these amounts to no more than $15,000/year. If the employee is over 50 years of age, he or she can make “catch up” contributions of an additional $5,000/year.
In addition to offering the 401(k) program, many employers offer matching contributions to their employees. While employees own whatever contributions they make into their 401(k) plans, some contributions by companies require becoming “vested” before being entitled to the contribution made by the company. For example, some companies require a specific time commitment on the job before employees retain the rights to their matching contributions. This may work as a one-time threshold or as a graduated process (that is, a series of time thresholds associated with specific amounts).
Most 401(k) plans offer a number of investment options. It is up to the employee to decide how the money will be allocated among these options. The choices made in this regard are critical in determining the ultimate value of the 401(k). As a result, it makes sense that anyone investing in a 401(k) should spend time educating him- or herself about the options and their risks and rewards. Many individuals split funds among a variety of options and risks to avoid “putting all their eggs in one basket,” so to speak.
Possible investing options include:
* stable value funds
* company stock
* mutual funds: money market mutual funds, bond mutual funds, stock mutual funds, index mutual funds, growth mutual funds, income mutual funds, growth and income mutual funds, aggressive growth mutual funds, and international funds
* balanced funds: lifestyle or asset allocation funds
Each type of investment option has degrees of certainty and risk, and one way that employees manage that risk is to diversify. It is key to remember that, unlike savings in a bank, 401(k) options are not insured by the Federal Government. Furthermore, past performance of an investment option cannot guarantee a good future result.
In making investment decisions about a 401(k) plan, it is helpful for the employee to ask him- or herself the following questions, so as to develop the best investment strategy:
* Have I learned all that I can about each investment option offered under the 401(k) plan?
* How has the investment option performed?
* How long do I have until I need the money for retirement?
* How should I select and mix these investments to work best for me?
* Am I a conservative, moderate, or aggressive investor?
Getting the Most from a 401(k)
The key to success for any investor or employee who participates in a 401(k) plan is to begin the process early and contribute the maximum allowable level to the plan. If it’s not possible to contribute the maximum amount, set a goal to increase the contribution level each year until the maximum is reached. Always try to take advantage of any matching contribution on offer from the employer. Monitor the 401(k) plan’s progress on at least a yearly basis, and adjust the investment mix to seek optimal returns, based on a comfortable level of personal risk. Careful planning today will ensure that adequate retirement funds will be available when they are needed tomorrow.