401k Information

What 401k information should I be aware of?

First of all, what is a 401k? 401k is a section of the IRS code that defines a plan where an employee can make pre-tax contributions. The money is automatically taken out of each paycheck and invested in funds that you choose from a small selection of funds given by your employer.

Note: The real way name is "401(k)," but, for simplicity's sake, I will call it "401k."

In 2009, the maximum contribution you can make 401k if you are age 49 or below is $16,500. If you're age 50 or above, that is $22,000 instead.

What are the advantages of a 401k?

Pre-tax contributions are great because they actually reduce your taxable income. For example, if you earn $50,000 gross income in a year and put $10,000 in your 401k, then you will only be taxed as if you made $40,000. You'll be able to make investment returns on that $10,000 until you pull it out during retirement years. When you pull it out, you will pay taxes on the $10,000 and any gains. By postponing the taxes paid, you're increase your investment returns.

Lowering your taxable income has additional benefits other than making your investment returns higher. Sometimes it will allow you to qualify for tax breaks only available to people who make less than you. For example, if you make too much money, you cannot contribute to a Roth IRA. Also, if you're in the 33% tax bracket by $5000, then you're only taxed 33% on that $5000. The rest of the earnings is taxed at a lower rate. Therefore, if you lower your taxable income by $5000, none of your income were taxed at 33%.

Most employers give additional incentives to invest in a 401k. The most common incentive is 401k matching. In this case, the employer will double the amount you put into your 401k up to the percentage amount. For example, if your employer does 5% matching and you put in 10% of your pretax income, then your employer will put an additional 5% -- bringing the total invested into your 401k to 15%. If you put in 3% and your employer matches up to 5%, then your employer will only put in 3% additional -- for total of 6%. Not taking advantage of at least the full match is like leaving free money on the table. My employer matches a percentage of my 401k and a full 25% of my 401k is from to their contributions.

Some employers give a certain percentage of income without having you having to do anything. Others give no matching. If you're unsure call your HR department.

Another nice benefit of the 401k is that it is set to automatic. This keeps away our worst enemy -- ourselves. By not having to manually invest our 401k every time we are prevented from finding excuses not to invest money. On top of protecting us from ourselves, being automatic is easy and forces us to practice dollar cost averaging.

What are the disadvantages of investing in a 401k?

The funds that your employer offers are usually limited to a small selection and may be poor choices. If all the expense ratios are high (Above 0.4% if you want to be picky. Over 1% is definitely too high.) and there are no index funds or target retirement funds offered, then your employer is doing you and your co-workers a disservice. Call your HR department and explain to them that the 401k options are needlessly expensive.

If have to pull it out before age 59 1/2, you may have to pay a 10% penalty fee. If you are over 55 and retired, then you do not have to pay the 10% penalty fee.

How do I invest in a 401k?

Most large companies will have a website with which you can select or funds your contribution percentages. If you are unsure how to invest your 401k call your HR department. My company has an easy website where I can select what percentage of my income to put in and what percentage of my contributions go to which selected funds.

What funds should I choose to invest in? Got any 401k tips?

The answer to this really depends on what your company is offering you. The most important thing to look for a low expense ratio. The 2nd most important thing to look for is a way to protect your retirement fund from yourself.

If they offer target retirement or lifecycle funds that don't have a high expense ratio, then select the one that corresponds with when you want to retire. For example, if you were planning on retiring in 2025, you would select 100% of your contributions to go into the "target retirement 2025" fund. Nice and simply -- the way I like it.

If you can't get a low-cost target retirement fund, look for a low-cost general stock fund and a low cost general bond fund. Put a percentage about equal to your age into bond fund and put the rest into the stock fund. Rebalance when the percentages get too far off your target.

If there are no low-cost options available, call your HR department and ask them why they have only funds with high fees in your 401k options.

Do not, I repeat, do not put your retirement money into your company's stock. Your financial future is already heavily tied to your company. If your company does well, you will likely keep your job and will continue to make financial contributions to your retirement account. However if your company does poorly -- along with the stock -- then your job may be at risk. It is wise not to put your retirement account at risk at the same time as your job. Remember those poor people that put all their retirement money into Enron? Its sad, but at the same time, they made an extremely unwise decision with their money.

What if my employer doesn't offer a 401k plan?

If you're self employed, check out the SEP IRA. Otherwise, check out Roth and Traditional IRA's. Unfortunately, without a 401k or SEP IRA, you're severely limited in the contributions you can make to tax sheltered accounts. Call your HR department and ask if there are plans to offer a 401k plan. If they say no, band together with your co-workers to let them know that it is something you all want or even need to successfully invest for retirement.

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