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Make The Most of Your 401K

As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. 

That’s because 401(k) plans offer a variety of attractive features that make investing for the future easy and potentially profitable. Be sure to talk to your employer or plan administrator about the specific features and rules of your plan.
 

What Is A 401K?
A 401(k) plan is an employee-funded savings plan for retirement. It takes its name from the section of the Internal Revenue Code that created these plans. 401(k) plans are also known as “qualified defined contribution” retirement plans: qualified because they meet the tax law requirements for favorable tax treatment (described below); and defined contribution because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.

Tax Treatment of 401(k) Plans
The 401(k) plan allows you to contribute up to $15,500 of your salary in 2008 to a special account set up by your company. Future contribution limits will be adjusted for inflation. Keep in mind that individual plans may have lower limits on the amount you can contribute. In addition, individuals aged 50 and older who participate in a 401(k) plan can take advantage of so-called “catch-up” contributions of an additional $5,000 in 2008.

401(k) plans now come in two varieties: traditional and Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.

The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax free; you pay no taxes on qualified distributions.

Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after 59 ½ (or age 55 if you are separating from service from the employer whose plan the distributions are withdrawn), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.

If your plan permits, you can make contributions in excess of the 2008 limit of $15,500 ($20,500 if over age 50), as long as your total contribution is not more than 100% of your pretax salary, or $46,000 in 2008, whichever is less. That means if your salary is $100,000, you can contribute up to $46,000 total to your 401(k) plan during 2008. In the case of a traditional 401(k), however, only the first $15,500 ($20,500 if over 50) of your contributions can be made pretax in 2008; contributions over and above that amount must be made after tax and do not reduce your salary for tax purposes.

Matching Contributions
Besides its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a Traditional 401(k) plan, is taxable when withdrawn.

Employer contributions may require a “vesting” period before you have full claim to the money and their investment earnings. But keep in mind that if your company matches your contributions, it’s like getting extra money on top of your salary.

401k graphic

Tax-Deferred Compounding
The benefit of compounding reveals itself in a tax-advantaged account such as a 401(k) plan. As the accompanying chart shows, if your $100 monthly contribution accumulates tax deferred over 30 years, you could grow your retirement nest egg to $150,030. That’s a difference of almost $50,000 just because you didn’t have to pay taxes up front!1 Of course, you’ll have to pay taxes on earnings and deductible contributions to a traditional 401(k) when you withdraw the money. But that will likely be when you are retired and may be in a lower tax bracket.

Choosing Investments
Generally, 401(k) plans provide you with several options in which to invest your contributions. Such options may include stocks for growth, bonds for income, or money market investments for protection of principal. This flexibility allows you to spread out your contributions, or diversify, among different types of investments, which can help keep your retirement portfolio from being overly susceptible to different events that could affect the markets.

When You Change Jobs
When you change jobs or retire, you generally have four different options for what to do with your plan balance. You can keep the plan in your former employer’s plan, if permitted; you can transfer balances to your new employer’s plan; you can roll over the balance into an IRA; or you can take a cash distribution. The first three options generally entail no immediate tax consequences; however, taking a cash distribution will usually trigger 20% withholding, a 10% IRS penalty tax, and ordinary income tax on pretax contributions and earnings.

When deciding on which of the first three options to choose, you should consider available investment options and ease of access. Often, rolling over to an IRA provides the greatest flexibility and control, while affording a wide choice of investment alternatives.

Borrowing From Your Retirement Plan
One potential advantage of many 401(k) plans is that you can borrow as much as 50% of your vested account balance, up to $50,000. In most cases, if you systematically pay back the loan with interest within five years, there are no penalties assessed to you.
If you leave the company, however, you may have to pay back the loan in full immediately, depending on your plan’s rules. In addition, loans not repaid to the plan within the stated time period are considered withdrawals and will be taxed and penalized accordingly.

Work With Your Financial Advisor
A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult with your plan administrator or financial advisor to help you determine how your employer’s 401(k) plan could help make your financial future more secure.

1This example is hypothetical in nature and is not indicative of future performance in your retirement plan. Withdrawals prior to age 59 ½ are subject to a 10% IRS penalty tax.

Points to Remember

  1. A traditional 401(k) plan allows you to defer taxes on part of your salary. A Roth 401(k) accepts after-tax contributions, but allows for tax-free withdrawals in retirement.
  2. Contribution limits are $15,500 in 2008 ($20,500 if age 50 or older). Future contribution limits will be indexed for inflation.
  3. One of the biggest advantages of 401(k)s versus other retirement plans is that employers may match part or all of the contributions you make to your plan.
  4. 401(k) plans provide you with several options in which to invest your contributions.
  5. If you leave your company and take a cash distribution, taxes and penalties will likely apply.
  6. Some 401(k)s allow you to borrow as much as 50% of your vested account balance, up to $50,000.

This article is not intended to provide specific investment or tax advice for any individual. Consult me, your financial advisor, or your tax advisor if you have any questions.

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