Investing in a 401(k)

401(k) retirement planning can make the difference between a financially secure retirement and the specter of running out of money. So it is very important to understand every aspect of how your 401(k) plan works. This is true whether you are just getting started or you're already retired.

In 1978, Congress decided that Americans were simply not doing enough to save for retirement, and thus, to ensure that they did not end up with a bunch of elderly people in need of financial support, they recognized American's needed a bit of encouragement to save more money for retirement. They figured out that if they gave people a way to save for retirement while at the same time lowering their state and federal taxes, they might just take advantage of it. Thus came the creation of the 401(k). In 1978, the Tax Reform Act was passed, and a portion of it authorized the creation of a tax-deferred savings plan for employees. The plan got its name from its section number and paragraph in the Internal Revenue Code -- section 401, paragraph (k).

So, now let' take a look at what this means for you.

As a way to accumulate retirement savings, you may have the opportunity to participate in a plan that your employer provides. These plans can offer tax benefits and the opportunity for your savings to compound over time. While some employers offer benefit plans that are defined as pensions or cash balance plans this is strictly about what a 401(k) is and what this type of retirement account does.

First, let's look at the advantages.

The advantages are general, and are better for some than others, however, there are great advantages to using a 401(k) to plan for retirement, namely:

Free money from your employer: most employers will contribute to your retirement account if you will.

Lower taxable income: Anything you contribute comes off your taxable income, and is taxed later. There are restrictions to how much you can contribute each year.

Savings and earnings that accumulate without you having to remember to make deposits: this is probably the biggest advantage. The contribution is taken out before you get your check, so you never see the money, and thus you do not miss it, giving you the means to save for retirement.

The opportunity to retire and not have to worry about money anymore: you can't really retire if you do not have money to live on since the fact is you simply can't realistically live off of social security alone.

The 401(k) is one of the most popular retirement plans around.

401(k) plans are a kind of defined contribution plans. Most employers offer some kind of retirement plan in this category. These plans do not promise a specific pension but provide retirement income based on:

The amount that's contributed to the account
The way the contribution is invested
The return the investments provide

401(k) plans are also referred to as salary deferral plans. This means that you can put part of your earnings into a retirement savings account, before you are taxed. Your employer may contribute (or match) to your account as well. Usually, if your employer offers some sort of 401(k) plan they are going to contribute as well. This can be as much as matching your contribution up to 15% of your salary, or it can be a maximum employer contribution each year, or a percentage based contribution, etc.

It is important to understand though that salary deferral plans are generally self-directed. This means that you are responsible for deciding how to invest the money that accumulates in your account. Your employer will typically have a variety of options to choose from. Usually this means that you must choose among a list of investments the plan offers, but in some cases you have more leeway. The advantage of this self-direction is that you can select investments that you believe will help you achieve your long-term goals. For example, you may choose to avoid investing in stocks because you do not want to see your retirement go down the drain during a market crash, or it might mean you invest more aggressively for a time because your retirement is still pretty far away, and then reallocate it when your retirement is getting closer.

When you participate in a traditional 401(k) plan, the taxable salary that your employer reports to the IRS is reduced by the amount that you defer into your account. This means the income taxes on that money are postponed until you withdraw from your account, usually after you retire. So, you do not have to pay taxes on the contributions until you withdraw them. It is important to note however that if you participate in a Roth 401(k), though, the amount you defer doesn't reduce your taxable income or your current income taxes, you still pay it. But when you withdraw money from the account after you retire, the amounts you take out are tax-free, provided you're at least 59½ and your account has been open at least five years. So in other words, investing in a typical 401(k) can be a great way to reduce your tax liability, but you don't just keep that money tax free, you pay the taxes on it later. If you invest in a Roth 401(k), then you get the tax advantage later. So, when deciding which to invest in, consider when you think would be the best time to get the tax advantage, now or later?

Another important issue to understand is that of vesting. Vesting means that you do not have a right to the money your employer contributes to your account (or the earnings made from those contributions), or makes to any other retirement account for you, until you are fully vested, or have full legal rights to your account. Vesting is determined by your time on the job. This can vary from job to job as some employer may determine a year of employment as 365 days from your first day on the job or as 1,000 working hours within a 12-month period, or in some cases it may even be as long as 3 years. This means that if you quit the job, or are fired before the vesting period is over, the money your employer contributed for you is null. Federal regulations set guidelines for vesting, but your employer determines which of the vesting schedules to use. It is important to note that any money you contribute to a salary deferral plan and the earnings those contributions produce always belongs to you though you usually must change jobs or retire to withdraw or move the balance.

Your money is protected by the government in that if you were to lose your job, or if the company you worked for went under, your retirement account would not be in danger. However, if you invest it poorly and lose it all, you have no protection there. So, it is important to recognize that if you want to build your retirement savings you can't just contribute, but you have to do the research to ensure that the way you choose to have invested is going to secure the amount you contributed, and hopefully earn you some more in addition.

The salary deferral plan that is available to you will depend on where you are working. Publicly and privately held corporations both typically offer 401(k) plans. Nonprofit organizations, such as schools and colleges, hospitals, and museums, usually offer 403(b) plans, but may offer 401(k) s as well. Many state and local governments offer 457 plans, and the federal government offers a thrift savings plans. These are all versions of 401(k) plans.

Your employee can limit the amount of contributions you can make to your 401(k) or at the very least, they will limit how much they will contribute, but the government does have a few restrictions. You can only contribute $15,000 a year. This is significantly higher than the amounts you can put in various other retirement accounts, and thus the reason it is one of the more popular options.

The reason your employer will contribute to your retirement is because they are given rules of compliance they have to follow.

Are there any drawbacks to the 401(k)? Yes, like anything when it comes to investments, there are some drawbacks, the 401(k) is no exception. If you withdraw your money before you are 59.5 years old, you'll have to pay the tax on it, PLUS a 10% penalty fine to the IRS. In some 401(k) plans, you can borrow from your account in the event of an emergency. You'll pay interest on it, but you are paying it to yourself. However, because there are disadvantages to this, it is always wise to check into your options fully before considering taking a loan against your 401(k).