What is a 401(k)?
401(k) plans are retirement vehicles that allow you to save pretax money for your retirement. That means your 401(k) contribution comes out of your gross income -- your salary before it's ripped to shreds by taxes.
You decide what percentage of your paycheck goes into your account. The maximum you can contribute for 2000 is $10,500. (This limitation should slightly increase each year.) If you get paid twice a month, that means you can contribute $438 a pay period. If you can contribute that maximum amount, do it because you do not pay taxes on your 401(k) contributions at this point in your life.
Because your elected contribution is automatically deducted from your paycheck, you barely know it's gone. So try to contribute as much as you can.
section 401(k) of the tax code, your 401(k) plan is set up by your employer, who works in conjunction with a mutual fund family or brokerage house to select some investment choices for you. You generally do not have the option of selecting which investment choices the plan will offer.
The number of investment options varies. You may have only a few choices or you may have tons. They will most likely be mutual funds and, in many instances, company stock. You decide which of these investments you want to buy with your contributions, and how much of your total contribution you want to put in each of your selected investments.
Be careful not to allocate too much to your company's stock. You know the old adage: You don't want to put all your eggs in one basket. You rely on this company for your current salary, you don't want to rely on it for your retirement, too.
So sock away as much money as you can. Then forget about it.
While you can borrow against your account for certain "hardships," like education costs or medical expenses, it's not recommended. You will have to repay the loan in after-tax dollars, and many plans don't let you contribute to your account until your loan is repaid.
So try not to touch those funds until you hit age 59 1/2, when you are allowed to take withdrawals, no questions asked. You'll owe ordinary income tax on the money withdrawn.
In some cases, employers will deposit money into your 401(k) plan. This contribution, a.k.a. an employer match, is usually a certain percentage of your original contribution. But it's free money, so be sure to take advantage of that match. For instance, if your employer generously matches up to 3% of your contributions, make sure you at least contribute 3%. Contributing only 2% leaves money on the table.
How Does It Affect Me?
Contributing to your 401(k) could be the difference between living in a condo on the golf course during your retirement or an apartment above the corner deli.
So the sooner you start to contribute to your 401(k), the better. Let's say you're 25 and you earn $40,000. If you start contributing 10% today, assuming an average rate of return on your investments of a mere 5% and an annual salary increase of 4%, at age 65, you'll have about $867,000. If instead, you don't start contributing until age 30, your nest egg drops to $742,000. That's $125,000 you lost by postponing your contributions. And the amount lost will continue to increase the longer you delay contributing.
If you're already in a 401(k) plan, awesome. Look at your payroll stubs and make sure that the amount you elected to contribute is being properly deducted from your paycheck. In addition, make sure the money's going to your selected investment choices.
Give Me an Example
"My 401(k) plan's choices are not that good. Besides, I can do better saving in my after-tax account."
Here's your example. In simplest terms, you make $60,000 a year and you decide to save 10% of your salary. If you put that $6,000 into your company's 401(k), you'd take home more money each year -- $38,880, to be specific. If instead you put $6,000 in an after-tax account, say your mutual funds, your take-home pay drops to $37,200. That's a $1,680 difference.
Save in After-Tax Account
Save in 401(k)
Tax Due (28%)
Where Do I Go to Learn More?
For more information on the basics of a 401(k), check out the
401kafe.com. The site has a great
calculator, which helps you determine what your 401(k) account will be worth when you retire.
If you're already in a 401(k) plan, you can input your investment choices into
financialengines.com. Based on the funds offered in your plan, the site will suggest a proper allocation.
And if you're looking for the legal-eagle angle, check out the
Pension and Welfare Benefits Administration
(a division of the
Department of Labor
Web site for more on your rights as a contributor as well as the responsibilities of your employer.