Retirement AccountsRetirement Accounts

401(k)401(k)

Stevie Chaikin

What are They Used forWhat are They Used for

401(k)401(k) retirement savings plan allows a retirement savings plan allows a worker to save for retirement and have the worker to save for retirement and have the savings invested while deferring current savings invested while deferring current income taxes on the saved money and income taxes on the saved money and earnings until withdrawal. earnings until withdrawal.

The worker elects how much money will The worker elects how much money will be taken out of his income and put into his be taken out of his income and put into his account. This is also called a “contribution”account. This is also called a “contribution”

Where it Comes fromWhere it Comes from

401(k) plans are mainly employer 401(k) plans are mainly employer sponsored plans; the employer can, as a sponsored plans; the employer can, as a benefit to the employee, optionally choose benefit to the employee, optionally choose to "match" part or all of the employee's to "match" part or all of the employee's contribution by depositing additional contribution by depositing additional amounts in the employee's 401(k) account amounts in the employee's 401(k) account or simply offer a profit sharing contribution or simply offer a profit sharing contribution to the plan. to the plan.

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HistoryHistory

In 1978, Congress amended the Internal In 1978, Congress amended the Internal Revenue Code by adding section 401(k), Revenue Code by adding section 401(k), whereby employees are not taxed on income whereby employees are not taxed on income they choose to receive as deferred they choose to receive as deferred compensation rather than direct compensation. compensation rather than direct compensation. The law went into effect on January 1, 1980, and The law went into effect on January 1, 1980, and by 1983 almost half of large firms were either by 1983 almost half of large firms were either offering a 401(k) plan or considering doing so. offering a 401(k) plan or considering doing so. By 1984 there were 17,303 companies offering By 1984 there were 17,303 companies offering 401(k) plans. 401(k) plans.

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There are LimitsThere are Limits

Maximum limit on the total yearly Maximum limit on the total yearly employee pre-tax salary deferral. The limit, employee pre-tax salary deferral. The limit, known as the "401(k) limit", is $15,500 for known as the "401(k) limit", is $15,500 for the year 2008 and $16,500 for 2009 and the year 2008 and $16,500 for 2009 and 2010. 2010.

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Small BusinessSmall Business The Economic Growth and Tax Relief The Economic Growth and Tax Relief

Reconciliation Act of 2001 (EGTRRA) made Reconciliation Act of 2001 (EGTRRA) made 401(k) plans more beneficial to the self-employed. 401(k) plans more beneficial to the self-employed. The two The two

key changes enacted key changes enacted related to the allowablerelated to the allowable

“ “Employer” deductible Employer” deductible

contribution, and the contribution, and the

“ “Individual” IRC-415 Individual” IRC-415

contribution limit.contribution limit.

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Tax ConsequencesTax Consequences

Most 401(k) contributions are on a pre-tax Most 401(k) contributions are on a pre-tax basis. Starting in the 2006 tax year, basis. Starting in the 2006 tax year, employees can either contribute on a pre-employees can either contribute on a pre-tax basis or opt to utilize the Roth 401(k) tax basis or opt to utilize the Roth 401(k) provisions to contribute on an after tax provisions to contribute on an after tax basis and have similar tax effects of a basis and have similar tax effects of a Roth IRA. However, in order to do so, the Roth IRA. However, in order to do so, the plan sponsor must amend the plan to plan sponsor must amend the plan to make those options available. make those options available.

Pros of 401(k)Pros of 401(k) Tax-Deferred:Tax-Deferred: Save on taxes now.  You will need to pay Save on taxes now.  You will need to pay

for it later though.  Your tax rate now will most likely be for it later though.  Your tax rate now will most likely be higher than during retirement.   If this is true, you’ll end up higher than during retirement.   If this is true, you’ll end up paying less in taxes and have more for retirement. paying less in taxes and have more for retirement.

Automated SavingsAutomated Savings:  The savings come out of your :  The savings come out of your paycheck so you never see it and it actually gets saved paycheck so you never see it and it actually gets saved rather than spent. rather than spent.

You Can Save A LotYou Can Save A Lot:  The amount you can save is :  The amount you can save is decent.  In 2009 it is $16,500 and it tends to rise. decent.  In 2009 it is $16,500 and it tends to rise.

Free Money  (Sometimes)Free Money  (Sometimes):  Your employer may match :  Your employer may match your contribution.  In this case, it is free money until you hit your contribution.  In this case, it is free money until you hit the contribution limit.  ie.  If you employer has a 50% match the contribution limit.  ie.  If you employer has a 50% match up to $5,000,  and you contribute $5,000, they will add up to $5,000,  and you contribute $5,000, they will add another $2,500 for a total of $7,500.  You should aim to get another $2,500 for a total of $7,500.  You should aim to get the maximum employer match whenever possible. the maximum employer match whenever possible.

Cons of 401(k)Cons of 401(k) You Do Pay Taxes EventuallyYou Do Pay Taxes Eventually:  In some situations, your tax rate now :  In some situations, your tax rate now

will likely be lower than during retirement.  This is more likely to be true will likely be lower than during retirement.  This is more likely to be true if you are… if you are… Early in your Career:   Your income is likely to grow by 2-3 times in Early in your Career:   Your income is likely to grow by 2-3 times in

the next 20-30 years. the next 20-30 years. Lots of Income Tax Deductions:  If you claim lots of income tax Lots of Income Tax Deductions:  If you claim lots of income tax

deductions due to a house or other reason that you don’t expect to deductions due to a house or other reason that you don’t expect to have during retirement, your tax rate now may be lower than in have during retirement, your tax rate now may be lower than in retirement. retirement.

FeesFees:  Some plans charge an administrative fee of 0.5% on to of :  Some plans charge an administrative fee of 0.5% on to of mutual fund expenses of 0.7%.  This can drag down your long term mutual fund expenses of 0.7%.  This can drag down your long term returns substantially. returns substantially.

Investment ChoicesInvestment Choices:  Most plans offer 10-12 investment options.  The :  Most plans offer 10-12 investment options.  The choices may not match your investment preferences or they may choices may not match your investment preferences or they may charge higher than normal expenses fees. charge higher than normal expenses fees.

Mandatory DistributionsMandatory Distributions:   When you are retired, you will be required :   When you are retired, you will be required to withdraw funds whether you need them or not and regardless of to withdraw funds whether you need them or not and regardless of your tax situation. your tax situation.

Alternates to your Alternates to your 401(k)401(k)

Roth IRARoth IRA:  So you can pay your taxes later with :  So you can pay your taxes later with a 401K or pay them now with a Roth IRA.  You a 401K or pay them now with a Roth IRA.  You need to earn less than $95,000 if you are single need to earn less than $95,000 if you are single and $150,000 if you are married.  Otherwise, and $150,000 if you are married.  Otherwise, anyone can open this account at a brokerage anyone can open this account at a brokerage and contribute up to $5,000 per year. and contribute up to $5,000 per year.

Roth 401KRoth 401K: This works similar to a 401K except : This works similar to a 401K except you put funds in after you’ve paid taxes on you put funds in after you’ve paid taxes on them.  Then you never pay taxes again. them.  Then you never pay taxes again.

Costs and Investment RisksCosts and Investment Risks

Besides the advantages offered by participation in a 401(k) plan, employees also may encounter certain costs and investment risks. Eligibility requirements, discretionary employee contributions, and matching company funds all can cause an employee to incur costs. In addition, investment risks, diversification or lack thereof, high record-keeping costs, the exercise of loan and withdrawal options, and fund distribution choices all can affect the level of an employee’s retirement benefits.

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