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It's a weird name for a retirement plan, but 401(k)s have arguably done more to get young people investing for their futures than anything else. The 401(k) savings plan was introduced in 1982 as a way for employers to save money they had been putting in pension plans.
Show Me the Money
A 401(k) is a type of retirement savings plan that enables employees to contribute a portion of their paychecks to a company-sponsored investment plan. A pension plan is an employer-sponsored retirement plan in which a retiree receives a fixed, periodic payment.
There have always been retirement plans. Employers used to (some still do) provide pension plans for employees. Basically, a pension plan is an employer-sponsored retirement plan, in which the employer contributes money to a retirement fund setup on behalf of an employee. Pensions were—and still can be—good for workers, because they basically provide additional job benefits. They don't cost workers anything. The downside of pension plans, though, is that they can make it hard for employees to leave their companies. If employees want their full pensions, they have to stay with the company until they retire.
Although pension plans aren't as common as they used to be, some companies still offer them. If you're considering a job that offers a pension plan, don't take the plan lightly when considering it as a benefit. After all, who can argue with an employer putting money aside on your behalf, with the understanding that it will be distributed to you bit by bit when you retire?
In contrast, 401(k)s enable employees to contribute a portion of their paychecks to a company investment plan until they leave the firm or retire. At that time, the employee's money can be either left where it is, rolled over into another retirement account, or claimed by the individual, who usually will face some penalties and an income-tax liability for taking the money early. This portability, the ability to take your retirement plan with you to your next employer, is one of the major reasons these plans are so popular.
A Match Made in Heaven
The 401(k) accounts (if your employer is a nonprofit organization, you'll have a 403[b] plan instead of a 401[k]) have been criticized for putting too much of the responsibility for saving on the employee and leaving the employer off the hook. Still, employers are not obligated to provide a defined benefit plan pension, and if they don't, 401(k) plans are an effective way of ensuring you that you'll have money available when you retire.
In addition to providing flexibility, 401(k)s may offer a great savings incentive by way of an employer match. The amount of the match varies from company to company. If you're really lucky, your employer will match dollar for dollar your contribution up to a certain percentage of your paycheck. The most typical match is for every dollar an employee contributes up to 4 percent, the employer throws in 50 cents. By taking advantage of the match, you get an automatic 50 percent return on your money. It doesn't take a financial wizard to figure out that that's a good deal!
Many firms match an employee's contributions with company stock. We all know that company stock can be a good thing, but it isn't always a good thing (ever heard of Enron?). If you're with a company that is matching your 401(k) contributions with company stock, just be sure to keep a close eye on the value of your account. While there are risks associated with getting company stock, for many employees it's better than not having any match at all.
Dollars and Cents
If it gripes you to have money taken out of your check every pay period to put in your 401(k), think about this. If, between the ages of 25 and 35 you contribute $5,000 a year to your 401(k), and you average 8 percent yearly earnings on your money, you'll be really happy that you saved when you reach age 65. Why? Because you'll have accumulated nearly $900,000 from 10 years of savings.
Investing in Your 401(k)
What happens to your money once it goes into the 401(k)? You get to decide where your money should be invested by choosing from a list of various investment options provided by your employer through the plan. If your employer has the 401(k) account in various mutual funds or a family of funds (which provide a variety of fund choices within the same company), you could divide your money between stocks and bonds with perhaps some fixed-interest rate investments or money-market funds thrown in for good measure.
Understandably, selecting investments can be a daunting proposition for someone who knows next to nothing about investments. But experts say that the process of choosing these options has served as a crash course for a lot of young people who would otherwise know nothing about investing money. They say that selecting in-vestments is not that complicated if you choose to keep it simple.
If you want a more detailed explanation of 401(k)s, check out Mary Rowland's book, A Commonsense Guide to Your 401(k). Rowland is a former personal finance columnist for The New York Times and the author of another book on mutual funds.
Employers have been reluctant to offer advice regarding their employees' 401(k)s because they're afraid that if their advice turns out to be wrong, they might be liable. Financial advisors, however, have come up with some guidelines to direct employees in investing their 401(k) plans. Most suggest that a conservative investor put at least 60 percent of the money in a large company U.S. stock fund (such as T. Rowe Price's Equity Income Fund). The rest, they say, could be divided between international stocks, small company stocks, and bonds. Your company should provide meetings about the various investment choices and how they pertain to you. If it doesn't, ask to have the service provided. You must understand your choices; your future depends on it.
Keep in mind that your 401(k) money is long-term money that you shouldn't plan to use until your retirement. This makes it conducive to equities—what most people consider the stock market—where you have to accept that your money is in for the long haul, and be willing to ride out the ups and downs of the market.
Tax Advantages of 401(k) Plans
Another great advantage of 401(k) plans is that the money you put into them is both pre-tax money and tax-deferred money. That means you win twice. Your 401(k) contributions are taken out of your salary before your salary is taxed for federal income taxes. The contributions are still subject to Social Security taxes, and some states subject the contributions to state and local income taxes. Still, not having to pay federal income tax on the money you contribute is a great benefit.
The money you contribute is also tax-deferred, which means you don't pay any tax on it or the money that it earns for you until you withdraw it, either prematurely or during retirement. An individual in the 25 percent tax bracket will pay 25 cents less tax on every $1 invested in a 401(k). Here's another way of looking at it: If you are a person in the 25 percent tax bracket who invests $100 per month in your 401(k), your federal tax liability will be $300 less per year than if you didn't invest in the 401(k).