Investing with Pre-tax Dollars in a 401(k)
A lot of companies offer 401(k) plans. Most savvy investors have participated in a 401(k) plan at one time or another. So why are so many people overlooking the easiest way to save money with pre-tax dollars? Do your children have this option at their current job? Have you explained to your children that a 401(k) is a tax-deferred investment option? Why are the young ignoring this opportunity? Informing the uninformed or educating your children sounds complicated. Below is the explanation of a 401(k) and questions for the employer. In future articles we will write for those of you who have a 401(k) and the strategies of how to manage your investment, the implications of changing jobs and borrowing against your 401(k). Here we will explain basic 401(k) facts and generalities and how they may affect your tax and financial picture.
In the early eighties, a consultant noticed that section 401(k) of an obscure tax law seem to allow employees to contribute part of each paycheck to an untaxed account while companies were allowed to match part of their contributions. The consultants' client company was not interested in creating such a plan so he started one for his own employees. The rest is history. Today as much as $2 billion of employee contributions per week pour into these plans.
How it Works
You authorize your employer to move part of each paycheck (up to $10,000 a year) into a special account to be invested in mutual funds and/or fixed interest rate investments provided by the plan. Once invested, the money grows tax free until it's withdrawn. Employers often match part of these contributions, giving you both a tax break, and, in effect, a raise.
Consider two portfolios, both of which start with $10,000 and earn 10% a year - about what common stocks have historically returned. The only difference is that the profits in the first portfolio are taxed at 20%, while the second is untaxed. In 10 years, the untaxed account has grown to around $24,000, about $3000 more than the taxed account. In 20 years, the gap has widened to $18,000. After 40 years, the second account has grown to $415,000, more than twice the size of the first. Hence, the benefit of avoiding taxes. This example assumes as single initial investment of $10,000 while a 401(k) lets you put that much away every year.
You can start taking money out of the 401(k) penalty-free, after age 59 1/2. You are required to start withdrawing it at age 70 1/2 (unless you are still working at the company that sponsors your 401(k) plan, in which case you can keep contributing until you leave). You can choose to take the whole thing, penalty-free, but then you will get hit with taxes you'll have to pay all at one time.
How to Judge a 401(k) Plan
Ask the following questions:
Does the company match my contribution? Studies show over 80% of employers with 401(k) plans match some part of their employee contributions. The total contribution cannot exceed 24% of your salary.
Does the company's 401(k) plan offer enough investment options? Most offer five or more choices, including a fixed-rate investment that pays the same interest rate for a given period of time, and several mutual funds featuring stocks, bonds, and/or money market instruments. Ask your plan administrator for the funds' historical returns; compare to major indexes like the S&P 500. Ask your tax professional to help evaluate if the funds' return is reasonable.
What is the waiting period to join? Very important! Most plans require new employees to wait one year before joining, though an increasing number are letting employees in on day one. This is very crucial to the young work force as they change jobs more frequently than the mature workforce.
When are the matching funds paid? Some companies make their matches at the end of the year but many have started paying the money out with each paycheck.
When do the matching payments vest? Your own contributions are your from day one, but the company's match "vests"- that is, becomes your property, over time. This usually takes between three and seven years.
Many small businesses have never had access to the hugely popular retirement accounts because of the expense and complexity of running them. Cheap and efficient technology is changing the dilemma the small business owner faced in the past. A software program called 401(k) Easy was created to help the small business owner manage 401(k) plans as easily as a consumer navigates family finances with software programs such as Quicken. This means the opportunity to participate in 401(k) plans will be more available for you and your children. A recent survey showed that 167,000 small businesses, representing roughly 1.6 million workers, expect to add a retirement plan in the next two years. Business owners are learning they can't afford not to offer retirement benefits if they want to hang on the their employees. The young work force is more educated and they expect a retirement package to be part of the negotiations for employment.
Many women going back to work after staying home for years and raising a family don't understand what a 401(k) is. You would be surprised at the number of middle to upper class citizens who have missed out on the opportunity to invest and grow their money tax-free. Your money will go further with a 401(k) plan than it would with any other investment plan. When you retire, it should pay more than you'll get from Social Security. You may have ignored this opportunity in the past for many reasons such as thinking you will not stay with the company long enough to reap the benefits of the 401(k). Possibly your job would become more appealing if you participated in the 401(k) or maybe the job change you have been considering would be more appealing to a company with a 401(k). Joining a 401(k) is not all you have to do to build a solid retirement plan. IRA's, life insurance, Social Security, real estate, and annuities should all be part of your plan. The 401(k) can be the centerpiece of a sensible financial plan and a brighter financial future.