Navigating the Retirement Saving Maze: 401(k) Plans

In the so-called good old days, employees of established companies didn’t have to worry about having enough money to retire on. The companies offered fully-funded pension plans that would take care of their employees’ retirement needs. All the employees had to do was work for the same company until they retired. Between the company pension and social security, they could live comfortably for the rest of their lives. Welcome to 1999. Most companies no longer offer funded pension plans. Almost nobody works for the same company their entire career. And the future of social security is in some doubt. So what can you do to assure a comfortable retirement?

Fortunately, there are other options

Congress recognized the need to encourage retirement saving and created several tax-favored retirement vehicles. Most require the employee to contribute the bulk of the money used to fund the plan but offer some tax breaks in return. Contributions to the plans are allowed to grow tax-deferred and sometimes the contributions are tax deductible. The biggest change in company retirement plans is the matter of responsibility. The company use to take care of everything. Now it is up to you to choose the best retirement vehicle (or to choose to participate in one at all). It is no longer automatic. You now have the responsibility to look after your own future. And, boy, can it be confusing.

This month, I will discuss 401(k) plans, probably the most popular retirement vehicle. 401(k) Savings Plans are available at most large companies and many smaller ones. Simply put, if your company offers a 401(k) plan, take advantage of it. There is no better way to save for retirement. Here is how it works. You allow your employer to set aside part of your salary each pay period for retirement. That money is exempt from current federal income taxes (and most state income taxes). The earnings on your contributions accumulate tax-deferred. You pay tax when you withdraw the funds, presumably sometime after you retire. Your plan may also allow after-tax contributions. There is no current-year deduction, but the earnings will accumulate tax deferred. The maximum employee contribution is some percentage of your salary, set by your company, up to a legal ceiling (currently about $10,000 - the maximum amount is adjusted annually for inflation). There are other limits on how much can go into your account. In some cases, higher-paid employees may not be allowed to contribute up to the legal ceiling. Although it is not required, the employer may match a percentage of your contributions. The amount of the match is up to the company (subject to limitations).

For instance, the company may contribute 50 cents for every dollar you contribute, up to 5% of your pay. Most 401(k) plans allow you to pick from four or more types of investments chosen by your company and managed by a financial institution (bank, brokerage firm, mutual fund company, etc.). Periodically, you are allowed to switch from one investment to another, within the plan. At least once a year, you will get a statement showing how your investments are doing. Although you are generally not allowed to withdraw funds from your 401(k) while you are still working for the company, most companies allow you to borrow from the plan under strict guidelines. If you leave the company, your 401(k) money goes with you. You are not taxed on the money as long as you elect to have the distribution rolled over into an IRA. Be careful filling out the paperwork to get your 401(k) distribution. The best option is to have the money rolled over directly from the 401(k) plan to your new IRA without you touching it. If the transfer is not handled correctly, you could wind up owing unexpected income taxes and penalties. Getting the most out of a 401(k) Plan - As long as the plan offers reasonable investment choices (almost all do), make the maximum pre-tax contribution if you possibly can. At the very least contribute up to the employer match. If you don’t, you are turning down free money. - Don’t allocate too much of your investment to your company’s stock, especially if the company matches your contributions in it’s own stock.

One of the keys to effective investing is diversification. If a lot of your 401(k) is tied up in your company’s stock, you are not properly diversified. - Most of your investment should be in stock-owning mutual funds. Your 401(k) is a long-term investment. Stocks (and stock-owning mutual funds) are much better long-term investments than bonds or money market funds. - If your company allows you to borrow from your 401(k) plan, it might be a useful resource for college planning. If you have to borrow for college for your kids, you’ll do better borrowing from your retirement plan (and paying interest to yourself) than borrowing from a bank. - If you work for a small company that offers a retirement plan, it may be a SIMPLE plan rather than a traditional 401(k). A SIMPLE plan is similar to a regular 401(k) plan. There are different contribution limits and other minor differences for the employer and employee. Generally, the recommendations that apply for a 401(k) are valid for a SIMPLE plan. What if your employer doesn’t offer any type of retirement savings plan? Don’t despair. That’s where IRAs (Individual Retirement Accounts) come in.

NEXT MONTH:

Traditional and Roth IRAs will be the topic of next month’s column.

Till later,

Scott

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Bio:

Scott Hill is a certified public accountant in Norcross, Georgia. He holds a Masters of Accounting degree and has over 18 years of experience. His firm, Scott Hill and Company, P.C., concentrates on accounting, income tax and financial planning for individuals and small businesses.

Financial advice for busy professionals with Scott Hill©

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