Savings Plan: The 4-1-1 on 401(k) – Part 2

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SAVINGS PLAN

A 401(k) savings plan is one of the most popular retirement plans around and can be an extremely effective investment vehicle if you’re lucky enough to have access to one. But getting the most out of a 401(k) requires an understanding of how employer contributions factor into your investment, as well as how — and when — Uncle Sam receives his due.

 

THE MATCH IGNITES RETURNS

Leveraging your employer’s contribution match is critical to making the most of a 401(k) investment. From the example in Part 1, Laura’s participation in Lemur Emporium’s 401(k) plan entitles her to receive the company’s matching contribution. That doubles the amount of her investment. By investing just 6 percent of her $50,000 salary for only one year, and having the Emporium match that with its 6 percent, at the end of 20 years (compounded annually and assuming an average 8 percent annual rate of return), Laura could have close to $28,000 — over 9 times what she personally put into the program.

If Laura stays at the Emporium until she retires and keeps contributing 6 percent with the company match, assuming she has a pay increase of 3 percent annually, by the time she reaches 60, she’d have saved more than $350,000. Without the company match, that amount would have been less than $180,000.

 

ARE THESE NUMBERS REAL?

There are a number of factors that have an effect on the final total in your bank account, such as how often deposits are made into your account and how frequently interest payments are compounded. Also, the rate of growth in the example — 8 percent — is near the historical, long-term average growth in the broad index of the New York Stock Exchange and a “base” figure often used by financial advisers; however, as we’ve seen, that rate isn’t always positive. Bull and bear markets can affect returns tremendously and even lead to year-to-year losses. You may choose not to invest in the stock market at all, putting your money into less risky investments such as municipal bonds, but you’ll likely also get a lower rate of return. You should talk to a seasoned financial adviser about your savings plan options before making decisions about where and how to invest. The one thing you shouldn’t delay, however, is starting your investment program. The sooner you start, the sooner you’ll begin building your own independent wealth.

 

THE TAX MAN DO COMETH

Yes, there is a day when taxes come due on that money — when it’s withdrawn. The IRS requires you to withdraw money from the account at rates determined by actuarial tables. You can begin taking withdrawals without a tax penalty at 59 1/2, but you don’t have to take them then. You can let the money keep working. At age 70 1/2, you must begin withdrawing the money and paying taxes on it.

 

So how is this tax-deferral thing beneficial if you’re going to end up paying taxes anyway?

Two ways: (1) you can earn investment returns on the amount that you would have paid in taxes, increasing the overall value of your account; (2) for many people, income decreases after they retire — less income means lower tax rates, so you’ll end up paying less in taxes on the money you invested when you withdraw it after retirement.

 

IS ALL OF THIS MONEY MINE, THEN?

All of the money you contribute from your salary — 100 percent of it — is owned by you from day one. The money contributed by your employer may be subject to a “vesting” period. Typically, the employer retains ownership of the contributions it makes to your plan at the outset, then transfers ownership of those amounts to you over time. That period of time is called the “vesting period.” You’ll typically get ownership over more of the employer’s contributions each year until the end of the vesting period, at which time you’ll own 100 percent of all contributions in the plan at that time, and 100 percent of all future contributions whether you made them or your employer made them.

 

WHAT IF I NEED THE MONEY BEFORE I’M 59 1/2?

In most cases, taking money out of your 401(k) savings plan before age 59 1/2 will require that you pay income tax on the money plus a 10 percent penalty. Be aware that, because the distribution may boost your total income for the year, your tax rate could increase, meaning you’d pay tax at a higher rate on all of your income.

This is to discourage people from “raiding” their retirement funds. There are some very specific circumstances under which the IRS will allow you to take money from the account without penalty. Check the IRS website or ask your financial adviser to see if your specific circumstances qualify for such a waiver. In some cases, it’s possible to take a loan from your 401(k) account. There are specific IRS guidelines about these loans, and plan sponsors (i.e., your employer) may impose additional rules, restricting loans against 401(k) accounts as well so be sure to check about your specific circumstance.

 

Sources:

https://www.investor.gov/tools/calculators/compound-interest-calculator#.U6SLTF66uRA

http://www.irs.gov/Retirement-Plans/Plan-Sponsor/401(k)-Resource-Guide—Plan-Sponsors—General-Distribution-Rules

http://www.bankrate.com/finance/retirement/penalty-free-401-k-ira-withdrawals-1.aspx