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401k Plans Explained by Gary Foreman
Hi Gary,
My uncle is very upset because he doesn't understand how his 401k works. He
thinks they are trying to tell him what he can do with his retirement money and
so forth. I don't know how to explain the basic point behind a 401k or how it
works. Can you help me?
-- Amber
Like most good things, the 401k retirement plan has some strings
attached. And the truth is that Amber's uncle is right. The company can, in
fact, control the choices for investing the money within the 401k plan. But, in
this case, it's a price that's usually worth paying.
The 401k plan has gained steadily in popularity. Total assets in 401k
plans passed traditional pension funds in 1996. An estimated $1 trillion
dollars are invested the plans. Studies show that 70% of companies with 100 or
more employees offer a 401k plan.
So it's not surprising that Amber's uncle has a plan available to him.
Many financial advisors encourage clients to use 401k's and IRA's to supplement
company sponsored pension plans and Social Security.
The 401k works pretty simply. The employer will select a plan
administrator. A number of investment options will be made available within the
plan. Typically the options will include a guaranteed vehicle (certificates of
deposit), a few mutual funds, and the employer's own stock (if it's publicly
traded).
The employee will be allowed to contribute a portion of their wages
into
the plan. There will be a maximum percentage. One of the big advantages to the
plan is that the amount you contribute reduces your taxable income. So if you
earned $50,000 last year and contributed $1,000, your taxable income is
$49,000.
You won't pay taxes on the 401k money until you withdraw it. Then
you'll
add any withdrawals to your ordinary income. And if you take money before age
59 1/2, you'll also face a 10% penalty except for certain loan options.
But, by delaying taxes on your contribution, it's like giving
yourself a
pay raise. For someone making $50,000 per year, a 2% contribution could save
them $280 in taxes.
The tax benefit also has a hidden effect. Since taxes aren't deducted
before you make your investment, you have a full $1 that begins to earn money
right away. That's a big difference. For instance if you had paid 28% in taxes
only 72 cents would have been invested. And that 72 cents would need to earn
nearly a 40% return before it would become $1 once again. Even in good markets
that takes a couple of years.
And that's only the beginning of the good investment news. Some
companies offer to match a portion of your contribution. For every $1 you
contribute they'll add 25 or even 50 cents. What that means is that you've
gotten a 25% or 50% return on your money before the investment does anything.
So even if the investment choices offered underperform your favorite by 10% or
so, it really doesn't matter.
Combined, those two benefits can create a very nice return on your
investment. For illustration, let's assume that Amber's uncle earns $50,000
annually as described above. He contributes 2% of his salary and the employer
matches 25 cents to the dollar.
What does Uncle get for his dollar contribution? Well, to begin with,
there's no taxes deducted from it. And, the company will add a quarter. So his
dollar is worth $1.25 before his investment does anything.
How would it compare if he invested it on his own? The dollar would be
taxed and he'd only have 72 cents to actually invest. His investment would need
to earn nearly 75% before it would equal the $1.25 that he has in the 401k
plan. Quite a difference.
For this privilege Amber's uncle will need to be willing to stay within
the investment selections available to him. But, even if they underperform his
real preference it will take a number of years before they make up the 75% head
start that the 401k investment has.
Within the choices available there are a couple of things that Amber's
uncle can do to make the most of his investment. Since the funds are meant for
retirement you'll be taking a longer view with the investments. That means you
can afford to take more risk than you could if you expected to need the money
in a year or two.
The second suggestion comes as a caution. Don't voluntarily buy company
stock. If the company hits on hard times, not only will your investment be
hurt, but you could also lose your job at the same time.
Finally, remember that it's money that you don't see. You don't need to
work at saving. It's safely put away before you'd have a chance to spend it.
Overall, a 401k plan is an excellent way to save. Amber's uncle could
find that the money he invests today will provide a significant portion of his
post-retirement income. And, yes, he's right. They are controlling his
investment options. But, in most cases, that's a cheap price to pay for the
benefits of a 401k plan.
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