The Ins and Outs of 401(k)'s

The Ins and Outs of 401(k)s

Does your employer offer you the option of investing in a 401(k)? Are you investing?

One of your primary sources of retirement income generally comes from private savings and investments. A defined-contribution plan provides you with an easy and painless way of creating this portion of your retirement fund.

What's a 401(k)?

A 401(k), named after the enabling section in the Internal Revenue Code, has become the retirement plan of choice for many private companies. If you work for a non-profit organization, this type of plan is referred to as a 403(b). For purposes of this article, we'll call both of these retirement plans 401(k).

A retirement plan such as the 401(k) is known as a defined contribution plan. This is quite different from the more traditional pension plans (known as defined benefit plans) that most of our older relatives and some of our friends have today. A 401(k) is a retirement savings plan that is primarily funded by you, the employee. Your employer will contract with a fund manager to administer the plan, but, as the owner of these funds, you are responsible for specifying how these funds are invested. The funds you put into a 401(k) plan are tax-deferred. This means you do not pay taxes on your earnings until you use them during retirement. Another important aspect of the 401(k) plan is that many employers will match a portion of the money that employees allocate.

Besides the traditional 401(k), there are the following:

Safe Harbor 401(k) – The Safe Harbor 401(k) plan exempts companies from tax rules that limit the amount of deferred salary contributions to the plan, as long as the employer makes a certain minimum percentage contribution to each participating employee's retirement account.
SIMPLE 401(k) – The Savings Incentive Match Plan for Employees (SIMPLE) 401(k) is a plan similar to the Safe Harbor 401(k) for businesses having 100 or fewer employees.
Roth 401(k) – The Roth 401(k) plan differs from a traditional 401(k) in that contributions are taxed at the beginning rather than at the end (when you close your retirement account and take the money). This is especially beneficial if your retirement account is held for many years. For more about this plan, see the Pension Rights Center factsheet What is the Roth 401(k)?

Remember that 401(k)s are retirement plans and can carry penalties for early withdrawals, so make sure you have carefully planned for your investment.

How Does It Work?

Most 401(k) plans are funded through payroll deductions. If your employer is contributing to your 401(k) plan, a certain amount is credited to your account at the same time as your contribution is deducted from your paycheck. Employer match programs vary widely, but there are some common approaches. For example, some companies will match, dollar-for-dollar, the amount you invest. If you contribute $50 per paycheck, your employer also credits your 401(k) with $50. Other employers will cap their contributions so they will only match your investment up to a certain amount. No matter what level of match your employer makes, you should try to take full advantage if you can. It's like getting a bonus every time you get paid!

In order to encourage people to save for their retirement, the Pension Protection Act of 2006 allows employers to automatically enroll you in their 401(k) plans. If an employer chooses to do this, a minimum of 3% of your paycheck will be automatically deducted and placed in your 401(k). You have 90 days after enrollment to notify the employer if you wish to opt out of the plan. If you wait more than 90 days to opt out, your funds are subject to income tax and a 10% withdrawal penalty. See the Pension Rights Center articleAutomatic Enrollment in 401(k)s for a detailed explanation.

Choosing Your Investments

Your employer will probably have a fund manager that takes care of your 401(k) plan. However, you are the one who decides how your money is invested, based on several choices the fund manager offers. If you are conservative, you'll likely choose low-risk investments in bonds or treasury certificates. If you are more of a risk taker, you may choose some aggressive growth and income stocks.As with any investment, you stand to lose principal if your investment decisions go awry. Make sure to allocate and diversify your investment choices to minimize the possibility of principal loss. To learn more about investing and allocating your investments wisely, read the related articles referred to in our Library.

What Happens If You Change Employers?

401(k)s are employee-funded, so it's your money! You take it with you when you leave. The good news is that if you are vested, you get to keep the funds your employer contributed as well. The term "vest" refers to your degree of ownership, based on the number of years of service to the employer. If you terminate your employment before you are vested, you will not receive the unvested portion of the employer's contribution, and it is returned to the employer.

For example, after three years you might be 40% vested, which means that you own 40% of the employer's contribution. According to law, you must become 100% vested after six years of employment if the employer is following a gradual vesting schedule. If the employer follows a cliff vesting schedule, you will become 100% vested after three years of employment, but will not receive any of the employer's contribution if you leave before that.

When It's Time to Retire

When you retire, you will generally be offered the following options to obtain the funds from your 401(k) investment:

Receive a lump-sum distribution. If you choose this option, you'll want to be very careful to reinvest your retirement funds cautiously. Remember, if you don't roll these funds into another tax-deferred investment, such as an Individual Retirement Account (IRA), your money will be fully taxable as soon as you receive it.
Withdraw your funds in installments over 5, 10, or 15 years. Each installment is taxed at your current tax rate when you receive it.

There are many things you'll want to evaluate before choosing your distribution options. In addition to assessing your other retirement income sources, you may also want to consider your age, health, marital situation, tax situation, and projected living expenses. You may have a benefits administrator who can run several "what-if" scenarios to help you decide on the best situation for you.

For more information about 401(k) retirement plans, read the Federal Citizen Information Center article Life Advice About 401(k) Plans.

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