401k Basics, Taxes, Investing

It seems as though people in the money industry thrive on confusion. They enjoy knowing cool numbers that mean neat things to boring people. If the discussion of topic doesn’t involve a 1040, 401k, or 403b it involves a SEP, Roth IRA, or HSA.

I won’t go into each of these today. But we should really take some time to talk about the basics of a 401k.

Planning for retirement is crucial. The time-value of money principle has proven itself time and time again. You have to begin saving for retirement as soon as possible. However, you must make sure your financial situation allows it. If you have done the following four things then you are ready to begin investing for retirement:

1. Stop living paycheck to paycheck.
2. Begin budgeting your money and sticking to it.
3. Get out of debt except for your home.
4. Save three to six months’ expenses in a liquid account (I recommend Betterment).

Once you have these four steps down, you can begin thinking about retirement.

I admire the fact that some people want to begin investing for retirement early, but if you have debt, that is probably not the wisest financial decision. For example, suppose you have a $3,000 balance on your credit cards with an interest rate of 9%. You’re anxious to begin putting some money away so you start a retirement fund that could potentially earn 10% per year. If you would simply pay off your credit card balance you would, in effect, be making a guaranteed return of 9%! Make sure you have completed the first four steps mentioned above before you begin worrying about retirement (an exception might apply if you have massive student loans, i.e. they’re the size of a mortgage).

On to the 401k basics. Once you begin investing for retirement, you should first look to your company’s basic 401k plan if there is an employer match involved. The reasoning behind this is pretty straightforward. If you work for a company that matches 2 for 1 then that would mean that for every $1 you invest into your 401k, your employer invests $.50. This is essentially free money. To not be contributing to an employer-matched 401k is like flushing money down the toilet. Holding all other things constant, if your employer matches your donation 2 for 1 then you are making a return of 50% on your investment. That’s not too shabby, partner.

In general, payments are auto-deducted from your paycheck. This is advantageous to many people who lack the discipline to not spend that money as soon as it touches their hands. It’s also pretty darn convenient – one less thing you have to worry about doing each time you’re paid.

Your 401k contribution, along with your employer’s matching contribution, will usually be invested in some type of a mutual fund. Some companies allow you to invest in company stock – even at a discount. My heart aches for those Enron employees who lost all of their retirement savings when Enron collapsed. Please, please don’t put all of your eggs in one basket. Diversify.

Diversification is accomplished quite easily with a mutual fund. Generally with a 401k plan you’ll be given several fund choices. I am partial to index funds for their ease of administration and low expenses. In the long run, with an index fund you will out-perform 2/3 of investors. You will of course, under-perform against the other 1/3. Make sure to choose a fund with a risk profile you feel comfortable with. If your allocation doesn’t allow you to sleep at night then it’s probably not worth it to you. Understand what you’re investing in and keep it simple.

The tax implications of a 401k are powerful and in your favor as long as you play your cards right. Generally, contributions to your 401k are made pre-tax, which saves you the amount contributed times your tax rate. For example, suppose you have an income of $100,000 without contributing to your 401k. If you contribute $10,000, then your taxable income will now be just $90,000. If you were taxed in the 30% bracket without having made the contribution, you would owe $30,000 in taxes. If you make the contribution however, you would only pay $27,000. You save $3,000 in taxes for contributing to your own retirement!

Another tax advantage to the 401k is that all of your earnings from your investment are tax deferred. Let’s do another hypothetical. Suppose you invest $10,000 just one time into your 401k and then sit on it for 40 years. After 40 years you withdraw the money and pay taxes on the entire amount. You would end up with $316,815. What if you just invested into a mutual fund that had no tax advantages? You would have $149,755. Less than half! The 401k is a powerful vehicle to minimize your tax bill while maximizing your return on investment.

Be warned: the 401k is there for retirement. The IRS imposes a 10% early withdrawal penalty if you’re under age 59 1/2 which can be absolutely devastating to your growing nest egg. Avoid withdrawing your 401k at all costs. If you have followed the steps outlined at the beginning of this article, the chance of you needing to borrow against your 401k balance is very, very slim.

There are limits to how much you can invest in your 401k. In 2004 the IRS has capped the contribution limit to $13,000. Current law provides for growth of the annual contribution limit to match cost-of-living increases. Currently the contribution limits are set to increase by $1,000 each year until 2006, where it will be $15,000.

If you change jobs, start your own business, or are laid off, there are a few options available to you regarding your 401k:

1. Take a cash disbursement. This is the absolute worst choice. Your employer is required by law to withhold 20% of the disbursement amount to pay your taxes, and if you are under 59 1/2 years of age then you will also be assessed a 10% early withdrawal penalty. Something else to keep in mind is that your tax liability for the disbursement may be greater than 20%, which would leave you with taxes to pay that you may not have anticipated.
2. Leave the investment with your employer. This choice is much better than the first. If you choose to leave it with an employer it continues to grow tax-deferred. You would most likely end up opening another 401k at your new employer and begin contributing to that. Switching between jobs can cause quite a bit of confusion with your retirement funds, however. Many people find it hard to manage funds when they are spread in many different places, which may lead to sub-optimal investment performance.
3. Transfer your 401k to your new employer. This is a solid choice. You end up having your investment under one administrator, which makes it easier to manage and monitor. Not every employer allows you to do this, which might make the last option your best choice.
4. Rollover the 401k to an IRA. This option is a great choice for a couple different reasons. First, you can always rollover and don’t have to worry about whether your employer accepts transferred 401k plans. Second, a traditional IRA offers all of the tax advantages of a 401k plus increased flexibility. You can invest in almost anything you want with an IRA, while a 401k’s choices are limited by the employer plan options (usually 10-15 different funds).

One other important term you might want to be familiar with is vesting. Most companies have certain requirements regarding when the contribution they make on your behalf actually becomes your money. Usually you have to work a certain number of years before the employer contributions are vested. Being vested simply means that those funds now belong to you and you can do with them as you please. If your company’s vesting requirement is 3 years, and they’ve matched your contributions at all, it would be a good idea to stick it out if you’re thinking of quitting with 2 years and 8 months left. You could be leaving a lot of money on the table! Not only would you be letting go of the amount contributed, you’d also be letting go of any capital gains attributed to that amount and any future capital gains that amount would have earned for you.

If you’re over the age of 50 and need to move quickly in planning for retirement then the 401k is still a great vehicle. Current legislation allows anyone 50 years of age or older to contribute an additional $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. Many plans offer these catch-up contributions, but check with your employer first to make sure.

The 401k is there for your use. It’s a powerful, tax-advantaged tool when used correctly and should belong in your arsenal of retirement savings weapons. Hopefully this basic 401k discussion has helped you. Use it wisely.