Planning for retirement is a lot easier if your employer offers 401(k) plans. But the difficulty comes in knowing how much to contribute, what risks to take, how to manage your funds and how to remove money or take a loan against your 401(k). Especially for those just starting out in the workplace, when your HR department mentions their 401(k) plan, they might as well be speaking Greek. Vesting? Money market accounts? High risk? What does it all mean?
What is a 401(k) plan?
A 401(k) is an employer-sponsored retirement plan. It allows you to take a certain percentage of your income and invest it pretax. So really, a 401(k) is like a savings account. The difference is, you contribute money that will then be invested into money market accounts and other funds to gain interest. Most employers will match a certain percentage of the funds you contribute to your 401(k). This means your employer is giving you free money based on your own contributions to your retirement fund.e contributed. You’ll make interest on top of that.
To find out what you could have waiting for you when you retire, use a 401(k) calculator, like this one offered by Bloomberg.com.
What are the benefits of a 401(k) plan?
If free money isn’t enough of a benefit of a 401(k) retirement plan, here are some other benefits. These might just push you over the retirement planning edge:
What do you need to know about 401(k) vesting?
While every dollar you contribute to your 401(k) plan is yours from the get-go, the dollars your employer contributes may not be. Every employer has what’s called a vesting schedule. This lays out the timelines the company has established for when an employee becomes 100% vested in the company.
Let’s say you’ve been with Company Cool for two years. You have been contributing money to your 401(k) since you started. But you might only have a right to 50% of the funds contributed by Company Cool. So if you were to leave Company Cool for Company Awesome, the amount of money in your 401(k) fund would decrease according to Company Cool’s vesting schedule. However, once you’ve been employed with Company Cool long enough to be 100% vested, then every dollar they’ve contributed and will contribute, is yours.
401(k) plan facts and rules
There are several 401(k) rules you need to know about before you can start maximizing your funds:
1) For 2007, the 401(k) contribution limit is $15,500 if you are under 50 years of age. If you’re over 50, then you can contribute an additional $5,000. While this is the government limit, you need to find out if your company has any limits set for their 401(k) plans.
2) You can start withdrawing funds at the age of 59 ½ without having to pay any penalties. But you have to have started withdrawing money by the age of 70 ½.
3) If you are over 55 and you’ve been let go by your company or are totally disabled, you can start withdrawing funds with no penalties.
4) Most 401(k) plans allow you to take loans against your account. You can usually borrow up to 50% of your savings. You are charged 10 percent interest if you can’t pay the money back in 5 years. If you leave your job before paying back the money, it must be paid in full in 30 days. Even if you can’t pay it back in 5 years, remember, you’re paying yourself the interest!
Managing your 401(k) plan
To get the most out of your 401(k), you need to contribute the maximum allowed each year by the IRS. For 2007 the 401(k) contribution limit is $15,500 if you’re under 50, and for 2008 the 401(k) contribution limit is $16,000. These figures do not include employee contributions. Some employers set their own limits on their 401(k) plans. So make sure you find out if lower limits apply to your plan. But whatever your limit, make sure you’re contributing as much as you can each year.
If you’d like to compare how much money you’ll make over the years depending on how much you can afford to contribute to your 401(k), use a 401(k) calculator (link this to Bloomberg calculator). It will help you decide how much to contribute from your monthly paycheck.
If you’re starting a 401(k) in your 20s, you can be rather aggressive with the funds and money markets you select from the list of sponsors. You can also recoup any losses from market fluctuation over the years by starting out early. While you can make rather aggressive choices for investments, it’s important that you do two things. 1: Research all of the available sponsors to help you make an informed decision. 2: Do not put all of your funds into high-risk investments. It’s best if you put your money into a variety of sponsors offering low-, mid- and high-risks.
As you get older, you’ll need to shift the bulk of your money from higher risk investments to mid- or low-risk sponsors. The closer you get to retirement, the more important it is for you to watch your investments to make sure that when you need the funds, they’ll be there for you.
To make a 401(k) plan work for you, you need to put in your own leg-work. Research all of the investments offered to make smart decisions. Keep up to date on the sponsors you’ve selected, because what was a wise decision two years ago may not be anymore.
Most plans offer a web site you can visit to view your account and various investments. You can check your balance, gains and the status of any new investment opportunities. It’s important that you do so on a regular basis. If a money market account you’ve invested in is losing money, you’ll need to find a better fund for your money so that you keep gaining.
The smartest thing you can do to financially plan for retirement is to start a 401(k) account. From there, how much you gain is up to how much you contribute, the research you put in and the up-keep you perform to make sure that your investments are working for you. And when it comes time to use money from your 401(k) account, remember the 401(k) rules so you minimize any penalties you might incur.
