401k for Dummies
Anyone familiar with the time value of money knows that even small amounts, when compounded over long periods, can result in thousands, or even millions, of dollars in additional wealth. This simple truth is one of the reasons many financial planners recommend tax-advantaged accounts and investments such as traditional/Roth IRA’s and municipal bonds.
In the past, these decisions were not as crucial because of the prevalence of defined-benefit pension plans.
Today, those old-world pensions are going by the wayside at many U.S. firms; instead, most of today’s workforce is likely to find their retirement years funded by the proceeds of their 401k retirement plan.
What a 401k Retirement Plan Is
A 401k retirement plan is a special type of account funded through pre-tax payroll deductions. The funds in the account can be invested in a number of different stocks, bonds, mutual funds or other assets, and are not taxed on any capital gains, dividends, or interest until they are withdrawn. The retirement savings vehicle was created by Congress in 1981 and gets its name from the section of the Internal Revenue Code that describes it; you guess it — section 401k.
The Benefits of a 401k Retirement Plan
There are five key benefits that make investing through a 401k retirement plan particularly attractive. They are:
- Tax advantage
- Employer match programs
- Investment customization and flexibility
- Loan and hardship withdrawals
Tax Advantage of 401k Retirement Plans
As touched on in the introduction, the primary benefit of a 401k retirement plan is the favorable tax treatment it receives from Uncle Sam. Dividend, interest, and capital gains are not taxed until they are disbursed; in the meantime, they can compound tax-deferred inside the account.
In the case of a young worker with three or four decades ahead of them, this can mean can mean the difference between living at the Plaza Hotel or the Budget 8.
Employer Match for 401k Retirement Plans
Many employers, in an effort to attract and retain talent, offer to match a certain percentage of the employee’s contribution. According to Starbucks’ “Total Pay Package” brochure, for example, the company will match a percentage of the first 4 percent of pay the employee contributes to their 401(k) retirement plan. Employees at the company for less than 36 months receive a 25 percent match; 36 to 60 months receive a 50 percent match; 60 to 120 months receive a 75 percent match; 120 or more months receive a 150 percent match.
In other words, an employee working at the coffee giant for over ten years earning $100,000 that contributed $4,000 to their 401(k) would receive a $6,000 deposit in the account directly from the company (150 percent match on $4,000 contribution.) Anything the employee deposited above the 4 percent threshold would not receive a match.
Even if you have high-interest credit card debt, it is preferable, in almost all cases, to contribute the maximum amount your company will match!
The reason is simple math: If you are paying 20 percent on a credit card and your company is matching you dollar-for-dollar (a 100 percent return), you are going to end up poorer by paying off the debt. Factor in the tax-deferred gains generated by the 401(k) plan, and the disparity becomes even larger. For more information on this topic, I suggest you read the work of Suze Orman.
Although the topic will be discussed in further detail later in this article, be aware that employer matching contributions up to 6 percent of an employee’s pre-tax salary are not included in the annual limit. For example, if you qualified, you could make a 401k contribution of $16,500 in 2009 and have your employer still match the first 6 percent of your salary; that match would be deposited above and beyond the $16,500 you contributed directly.
Investment Customization and Flexibility
401k retirement plans give employees a range of choices as to how their assets are invested. An individual that knows he or she does not have a high tolerance for risk could opt for a higher asset allocation in low-risk investments such as short-term bonds; likewise, a young professional interested in building long-term wealth could place a heavier emphasis on equities.
Many businesses allow employees to acquire company stock for their 401k retirement plan at a discount although many financial advisors recommend against holding a substantial portion of your 401k in the shares of your employer in light of the Enron and Worldcom scandals.
Investor's Options When Changing Employers
One of the benefits of a 401k retirement plan is that it can follow an employee throughout his or her career. When changing employers, the investor has four options:
- Leave His/Her Assets in the Old Employer’s 401k Retirement Plan: Many 401k plan administrators charge record keeping and other fees to manage your account, regardless of whether you are still with the company. These fees can take a significant bite out of your future net worth, especially if you have accounts maintained at several different employers.
- Complete a 401k Rollover to the New Employer’s 401k Plan: Practically speaking, this option is only available if the employee has another job offer before leaving their current employer. In some cases, a rollover IRA may be the best option as it is simple. How do you know if it is the right choice? The decision should largely be made based on the investment options of the new 401k plan. If you are unsatisfied with the choices available to you, completing a 401k rollover to an IRA may be a better option.
- Complete a 401k Rollover and Move the Assets to an Individual Retirement Account (Ira): Completing a 401k rollover is almost always the best choice for those interested in providing for a comfortable retirement because it allows the investor’s capital to continue compounding tax-deferred while providing maximum control over asset allocation (i.e., you aren’t limited to the investments offered by the 401k plan provider.) Here’s how it works: A distribution of the current 401k plan assets is ordered (this is reported on the IRS Form 1099-R.) Once the assets are received by the employee, they must be contributed into the new retirement plan within sixty days; this deposit is reported on IRS Form 5498. The government limits 401k rollovers to once every twelve months.
- Cash out the Proceeds, Paying Taxes and the 10% Penalty Fee: With the exception of failing to take advantage of an employer’s contribution match program, cashing out a 401k when leaving jobs is the single most stupid decision a working individual can make. According to a press release by the 401K Help Center, research indicates “as many as 66 percent of Generation X job changers take cash when leaving their jobs, and 78 percent of workers aged 20-29 take cash.” The tragedy is far greater than the taxes and penalty fee alone; indeed, the greater financial loss comes from the decades of tax-deferred compounding that capital could have earned had the account owner chosen to initiate a 401k rollover.
The purpose of your 401k retirement plan is to provide for your golden years. There are times, however, when you need cash and there are no viable options other than to tap your nest egg. For this reason, the government allows plan administrators to offer 401k loans to participants (be aware that the government doesn’t require this and therefore it is not always available.)
The primary benefit of 401k loans is that the proceeds are not subject to taxes or the ten-percent penalty fee except in the event of default. The government does not set guidelines or restrictions on the uses for 401k loans. Many employers, however, do; these can include minimum loan balances (usually $1,000) and the number of loans outstanding at any time in order to reduce administrative costs. Additionally, some employers require that married employees get the consent of their spouse before taking out a loan, the theory being that both are affected by the decision.
401k Loan Limits
In most cases, an employee can borrow up to fifty-percent of their vested account balance up to a maximum of $50,000. If the employee has taken out a 401k loan in the previous twelve months, they will only be able to borrow fifty-percent of their vested account balance up to $50,000, less the outstanding balance on the previous loan. The 401k loan must be paid back over the subsequent five years with the exception of home purchases, which are eligible for a longer time horizon.
401k Loan Interest Expense
Even though you’re borrowing from yourself, you still have to pay interest! Most plans set the standard interest rate at prime plus an additional one or two percent. The benefit is two-fold: 1.) unlike interest paid to a bank, you will eventually get this money back in the form of qualified disbursements at or near retirement, and 2.) the interest you pay back into your 401k plan is tax-sheltered.
The Drawbacks of 401k Loans
The biggest danger of taking out a 401k loan is that it will disrupt the dollar cost averaging process. This has the potential to significantly lower long-term results. Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days. Should the plan participant fail to meet the deadline, a default would be declared and penalty-fees and taxes assessed.
401k Hardship Withdrawal
What if your employer doesn’t offer 401k loans or you are not eligible? It may still be possible for you to access cash if the following four conditions are met (note that the government does not require employers to provide 401k hardship withdrawals, so you must check with your plan administrator):
- The withdrawal is necessary due to an immediate and severe financial need
- The withdrawal is necessary to satisfy that need (i.e., you can’t get the money elsewhere)
- The amount of the loan does not exceed the amount of the need
- You have already obtained all distributable or non-taxable loans available under your 401k plan
If these conditions are met, the funds can be withdrawn and used for one of the following five purposes:
- A primary home purchase
- Higher education tuition, room and board and fees for the next twelve months for you, your spouse, your dependents or children (even if they are no longer dependent upon you)
- To prevent eviction from your home or foreclosure on your primary residence
- Severe financial hardship
- Tax-deductible medical expenses that are not reimbursed for you, your spouse or your dependents
All 401k hardship withdrawals are subject to taxes and the ten-percent penalty. This means that a $10,000 withdrawal can result in not only significantly less cash in your pocket (possibly as little as $6,500 or $7,500), but causes you to forgo forever the tax-deferred growth that could have been generated by those assets. 401k hardship withdrawal proceeds cannot be returned to the account once the disbursement has been made.
Non-Financial Hardship 401k Withdrawal
Although the investor must still pay taxes on non-financial hardship withdrawals, the ten-percent penalty fee is waived. There are five ways to qualify:
- You become totally and permanently disabled
- Your medical debts exceed 7.5 percent of your adjusted gross income
- A court of law has ordered you to give the funds to your divorced spouse, a child, or a dependent
- You are permanently laid off, terminated, quit, or retire early in the same year you turn 55 or later
- You are permanently laid off, terminated, quit, or retired and have established a payment schedule of regular withdrawals in equal amounts of the rest of your expected natural life. Once the first withdrawal has been made, the investor is required to continue taking them for five years or until he/she reaches the age of 59 1/2, whichever is longer.
What is the maximum contribution limit on your 401k account? The answer depends on your plan, your salary, and government guidelines. In short, your contribution limit is the lower of the maximum amount your employer permits as a percentage of salary (e.g., if your employer lets you contribute 4% of your salary and you earn pre-tax $20,000, your maximum contribution limit is $800), or the government guidelines as follows:
401k Maximum Contribution Limits
- 2004: $13,000
- 2005: $14,000
- 2006: $15,000
- 2007: $15,500
- 2008: $15,500
- 2009: $16,500
- 2010: $16,500 plus inflation index (in $500 increments)
Once the year 2010 has been reached, the total maximum contribution limit will be increased based on changes in the cost of living in increments of $500.
Catch Up Contributions
If you are fifty years or older and your employer offers “catch-up” contribution for your 401k, you are eligible to contribute additional amounts up to the maximum contribution limits as follow:
401k Maximum Catch-Up Contribution Limits
- 2004: $3,000
- 2005: $4,000
- 2006: $5,000
- 2007: $5,000
- 2008: $5,000
- 2009: $5,500
- 2010: $5,500 plus an inflation index (in $500 increments)
A Reminder on Employer Matching Contributions and 401k Contribution Limits
Once again, employer matching contributions up to six-percent of an employee’s pre-tax salary are not included in the contribution. For example, if you qualified, you could make a 401k contribution of $16,500 in 2009 and have your employer still match the first six-percent of your salary; that match would be deposited above and beyond the $16,500 you contributed directly.