The 411 on getting a 401(k) – what's up

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Understanding retirement options and taking advantage of them can be a daunting, frustrating task. The terminology and complicated rules can make you want to keep your money in a tin under your mattress. However, even if you don’t plan on ever getting old, it behooves you to think about saving for retirement and educate yourself on how to make the most of your savings.

Fortunately, one of the most common ways of saving for retirement – the 401(k) plan – is a fairly straightforward plan to sign up for. Many companies match employees’ contributions with cash or stock, which is effectively free money for your retirement.

Be sure to talk with financial professionals about what opportunities make the most sense to you and how to go about saving and investing responsibly. While it might be a ways off, the goal is to retire someday and comfortably enjoy the years when you are finally, gloriously free of having to work for a living.

What exactly is a 401(k)?

A reference to section 401, paragraph K of the Internal Revenue Code that established it, 401(k)s are retirement plans offered to employees by private businesses. The idea is that you’ll put money aside to invest in some of these options, which will presumably grow and sustain you through your retirement. The 401(k) is administered by a third party, such as Vanguard or Charles Schwaab, but you decide what percentage of your paycheck goes into the plan each pay period, and the employer puts it in the account on their behalf.

There are a few major benefits to having a 401(k). Many employers will match a percentage of the funds contributed by an employee, or will offer stocks or other incentives to participate. Also, the money you put into a 401(k) is taken out of your paycheck before taxes are, meaning that not only do you not pay taxes on the money you invest, but that you pay less taxes overall since you are only taxed on the part of the paycheck that is left after your 401(k) percentage is taken out. The money you contribute to the 401(k) is not taxed until you withdraw money from the account when you retire, and, according to 401khelpcenter.com, any investment gains and earnings are likewise not taxed until the money is withdrawn.

Moreover, because a 401(k) is administered by a third party, your retirement savings are not tied to the success of your employer. In fact, it is illegal for an employer to physically hold the assets of its employee’s 401(k).

Who sets up a 401(k) and how is it done?

To establish a 401(k), your employer consults with a broker or investment manager to create a number of different investment options for employees. Typically, these include a variety of high to low risk options like stocks, bonds, mutual funds and money market accounts. Your employer is obligated to provide you with a summary plan description, giving you a comprehensive overview of the different options and how they work.

The downside is that the options your employer picks are the only options you have to choose from. However, these options can be numerous. According to CNN, the average plan has around 19 options, but Billy DeFrance, a certified public accountant at El Paso’s Lauterback Financial Advisors, said that he’s seen plans with more than 100 investment options. While this variety is good, the sheer amount of choices can be confusing for people who aren’t familiar with the obscure world of finance, so feel free to consult a trusted advisor when deciding where to invest.

He also noted that some 401(k) options include built-in commissions and fees charged by the brokers that ultimately mean less money for you.

“The key is to understand who benefits from your investments,” he said.

Contributing to a 401(k)

Once you have your 401(k) set up, it is pretty easy to contribute. You choose how much you want to contribute per pay period and your employer automatically takes it out of your paycheck and puts it into your 401(k) account.

There are limits to the amount you can contribute to your 401(k) each year. If you are under 50 years old, you can contribute up to $18,000 per year, while employees 50 and older can contribute an additional $6,000 per year, or up to $24,000.

Employers will often match contributions, or a percentage of them, while some employers offer what are called “safe harbor” contributions, which is a set amount regardless of how much an employee contributes to her account. The money an employer contributes is subject to taxes.

However, the money your employer contributes isn’t automatically yours. The funds are “vested” – you have to remain employed with your company for a set number of years before the money they’ve contributed is fully yours. After this time, however, you get to keep the money even if you take a different job.

Employers do have some latitude to restrict who can participate in the 401(k) program. According to 401khelpcenter.com, “individuals with a less than one-year service, union members, non U.S. citizens, part-time workers, etc.” may be ineligible for the plan.

Withdrawing your funds or rolling them over

Almost all plans require you to keep your money in the 401(k) until you are 59-and-a-half-years old. (After you turn 70-and-a-half, you are obligated to make minimum withdrawals from your 401(k).) According to CNN, “withdraw any of it before then and you’ll be hit with a bruising 10 percent early withdrawal penalty, on top of the regular income tax that is due on withdrawals” from 401(k) plans.

DeFrance said that in some cases, these fees and taxes could wipe out as much as 40 percent of the amount you are trying to withdraw. After you are 59-and-a-half, however, you can use the money as you’d like, though you of course still have to pay taxes on it.

However, if an emergency occurs, you can access the funds in your account without paying a penalty; you can borrow money against yourself by taking a loan out from your 401(k). You must pay the loan back within a set amount of time, or you’ll be charged all of the fees and taxes that you would an early withdrawal. (And you can only take out a loan using funds you’ve contributed, not those of your employer.)

But almost every single advisor cautions against treating your 401(k) like a savings account or an emergency fund because of how easily your 401(k) funds can diminish if you take them out or don’t pay back the loan. Withdrawing from a 401(k) is difficult on purpose, and the hefty fees are an inducement for you to leave the funds alone until you retire.

Fortunately, if you change jobs and sign on for your new employer’s 401(k) plan, you can transfer your old 401(k) savings to the new account without paying the taxes and penalties. Though, if you like your previous employer’s plan and are happy with the investments, you aren’t obligated to transfer the funds, DeFrance said. But in most cases, he said, you have to have at least $5,000 of vested funds in order to stay in your old account.

Two other things to consider

– There is another kind of 401(k) you might have heard about called a Roth 401(k). It functions as a sort of inverse to the traditional kind of 401(k) discussed above: in a Roth 401(k), you are taxed on the money you contribute from your paycheck, but aren’t taxed when you withdraw it when you retire. Speak with your advisor about the plusses and minuses of opening a Roth 401(k)

– Matching funds given by many employers sometimes come in the form of company stock. The CNN article notes that “experts recommend keeping no more than 5% to 10% of your total assets in the stock of your company.” One has to only recall the Enron debacle to understand why this is good advice.

– All in all, investing in a 401(k) is a really smart thing to do, DeFrance said, and the numbers speak for themselves.

“If a 25 year old invests $1,000 per year in a 401(k) at a 7.2 percent return, in 40 years, that $1,000 would be worth $16,000,” he said. “Smaller amounts invested early have the best chance of return and security in your retirement.”

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