MAKE THE MOST OF YOUR 401(K)

As more Americans need to take responsibility for their own retirement, many are relying on their 401(k) retirement plans to provide the means to meet the majority of 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.

What Is a 401(k)?

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 the benefit at retirement will not be defined until all contributions are made.

Tax Treatment of 401(k) Plans

The 401(k) plan allows you to defer taxes on part of your salary by contributing that amount (in 2004, up to $13,000; or a combined total of employer/employee contributions of 100% of pretax salary or $41,000, whichever is less) to a special account set up by your company. Keep in mind that individual plans may have lower limits on the amount you can contribute.  These plan-specific limits are established based on IRS rules to ensure that contributions to the plan continue to qualify for tax deferral. The contribution limit increases annually in $1,000 increments until it reaches $15,000 in 2006.  Thereafter, it will be adjusted for inflation. Also, individuals aged 50 and older who participate in a 401(k) plan are now able to take advantage of so-called "catch-up" contributions of $3,000 in 2004. The catch-up contribution limit is scheduled to increase in $1,000 increments, topping out at $5,000 in 2006.

You don't pay taxes on investment earnings on your contributions or amounts contributed by your company until the money is withdrawn, usually at retirement. In addition, because the amount of your pretax contribution is deducted directly from your salary, your taxable income for the year is reduced; as a result, so is your tax burden. For this reason, 401(k)s are commonly known as "salary reduction plans."

If your plan permits, you can make contributions in excess of the 2004 limit of $13,000, as long as your total contribution is not more than 100% of your pretax salary or $41,000, whichever is less. That means if your salary is $100,000, you can contribute up to $41,000 total to your 401(k) plan during that year. However, only the first $13,000 of your contributions is made pretax (in 2004); contributions over and above $13,000 must be made after-tax. That means excess contributions do not reduce your salary for tax purposes.

Matching Contributions

Besides its salary-reducing quality, one of the biggest advantages of 401(k)s versus other plans is that employers may match part or all of the contributions you make to your plan.

These employer contributions may require a "vesting" period before you have full claim to the money and their investment earnings.  Typically, employers match 50 cents for every dollar you contribute, up to 6% of your salary. If your company matches your contributions, it's like getting extra money on top of your salary. Both your contributions and your employer's (if any) compound tax-free until age 59 1/2, when the employee is eligible to receive distributions from the plan.

Consider the Advantage of Tax Deferral

Source: Standard & Poor’s.

As you evaluate the potential benefits of an IRA, consider the advantage of tax deferral. This chart shows the result when a hypothetical $100 monthly investment is made for 30 years in a tax-deferred plan versus the same investment taxed at 25%, assuming an 8% average rate of return compounded monthly

401(k) Advantages

• Tax deferral on contributions and earnings until withdrawal.
• Choice among different asset classes and investment vehicles.
• Potential for company-matched contributions.
• Possibility to take a loan from yourself and pay yourself back, with interest.

Tax-Deferred Compounding

The benefit of compounding reveals itself in a tax-deferred account such as a 401(k) plan. As the accompanying chart shows, if your $100 monthly contribution accumulates tax free over 30 years, you could grow your retirement nest egg to $121,522. That's a difference of more than $20,000 just because you didn't have to pay taxes up front!* Of course, you'll have to pay taxes on earnings and deductible contributions when you withdraw the money.  But that will likely be when you are retired and may be in a lower tax bracket.

Source: Standard & Poor’s.

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

A 401(k) is a company-administered plan, which means that changing or losing your job could affect management of the plan. While some companies may allow you to keep your 401(k) investments in their program until age 59 1/2, others will require you to move your money somewhere else.

In the latter case, your best option may be to directly transfer your 401(k) from your old to your new employer's plan. This means the check goes directly from your old company to your new company (and you never touch the money). If your new employer does not have a 401(k) plan, you can still directly "roll over" the funds into an individual retirement account (IRA) without touching those funds. In either case, no tax is withheld or owed on the direct rollover amount.

However, if you choose to physically receive part or all of your money and do not roll over the entire amount to another retirement account within 60 days, you may have to pay some significant taxes and penalties. 

Borrowing From Your Retirement Plan

Another potential advantage of some 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. Normally, funds cannot be withdrawn before age 59 1/2 except in cases of extreme hardship. In such cases, you will still be responsible for paying a 10% penalty and both federal and state taxes will be owed on the withdrawal.

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 financial advisor to help you determine how your employer's 401(k) plan could help make your financial future more secure.

Points to Remember

1. The 401(k) plan allows you to defer taxes on part of your salary.
2. You can make contributions in excess of the 2004 limit of $13,000, as long as your total contribution is not more than 100% of your pretax salary or $41,000, whichever is less. The contribution limit increases annually by $1,000 increments until it reaches $15,000 in 2006. Thereafter, contribution limits will be indexed for inflation. Older Americans may also make catch-up contributions to their 401(k) accounts.
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, choose to physically receive part or all of your retirement account balance, and do not roll it over into another retirement plan within 60 days, you will have to pay taxes and penalties.
6. Some 401(k)s allow you to borrow as much as 50% of your vested account balance, up to $50,000.
7. Loans not repaid to your 401(k) plan when due are considered withdrawals and will be taxed and penalized accordingly.
8. Borrowing from your 401(k) should only be a last resort.

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