401K

401 plans were first authorized by a section of The Tax Reform Act that Congress passed in 1978. It took several more years until the actual regulations were put into place. So beginning in 1982, taxpayers were able to begin making contributions to their plans for the first time. It wasn’t until 1991, however, that the final regulations were published.

The name of the program comes from the place where it is listed in the Internal Revenue Service tax code: section 401, paragraph (k).

Not every employee is eligible; those who work for tax-exempt organization, such as churches, public schools, or hospitals cannot participate. But for these employers, there are similar 403(b) plans available.

But the basic idea of each plan is the same: your employer deducts a certain percentage of your gross earnings from each paycheck and puts it into a retirement plan for you. Its all done automatically, with the amount deducted reported to you on each paycheck stub.

Your automatic deductions are done on a pre-tax basis. This doesn’t mean that they are “tax free,” it just means that you don’t pay taxes on these amounts until, ideally, you are at least 59 and ½ years old, you retire, and you start to receive distributions from your plan. (There are certain instances in which you can receive distributions from your plan before you are 59 and ½ years old, but you generally want to do this unless you have to.)

The tax-deferred contributions are invested in securities or stocks and are then allowed to grow until they are withdrawn when the participant retires. Unlike regular stock market investments, you are not faced with paying capital gains taxes when your 401k investments increase in value.

What does this mean right now, when you are making contributions to your plan? It means that your employer is reporting a lower adjusted gross income to your employer. Although you’re still making the same amount of money, according to the IRS, you’re making a smaller amount of taxable income and your tax liability is lowered. This reduces the amount of taxes you must pay at the end of the year.

For example, suppose that you receive a paycheck for $1,000. If you put $50 of that amount into a 401 k plan, your taxable income is only $950.

This is often considered one of the major benefits of a 401(k) plan. If you contribute enough to the plan, you might even put yourself into a lower tax bracket. In addition, because certain IRS credits, such as child tax credits, depend on a worker’s adjusted gross income, you may even lower your taxable income enough to be eligible for additional credits, while saving for retirement at the same time.

Because you lower your adjusted gross income when you contribute to a 401(k) plan, you also lower the amount of state taxes you must pay (if your state has a state income tax).

Of course you have to pay taxes on this income when you retire. But since incomes often drop when people retire, you may be in a lower income bracket by then and pay less in taxes.

With pension plans from employers now a rarity, the 401k-retirement savings plan may well be the main source of retirement income for many people. Utilize your human resources department to make sure you know what is available to you for retirement options, and that you understand your available benefits. Don’t wait for them to come to you, because they probably won’t.

Few middle- and low-income people are able to buy significant amounts of stocks and bonds on their own; most don’t have a broker. Few will have Certificates of Deposits or large amounts of savings. Few in this category are able to put money into 402 plans, or even understand how to utilize them.

Of course, there are always Social Security payments. But if you rely exclusively on that, you’re very likely to be disappointed. Social Security payments can be as low as several hundred per month. And unless the government radically changes the rules in the future, you’re not likely to receive more than a few thousand dollars a month from Social Security payments, regardless of how much you earned during your lifetime.

If you have to live on Social Security alone, that could represent a radical drop from your pre-retirement income. You don’t want to go from a middle-class lifestyle to poverty. Many of us dream that we’ll be better off after we retire; few of us realize that without careful planning things could be worse.

It is typical for employers to contribute matching amounts if employees participate in their 401(k) plans. Employers can match 100% of an amount contributed or a certain portion of the amount contributed. The goal, typically, is to get employees to contribute anything at all; many employees simply don’t participate.

During 2007, the most that anyone can contribute, on a tax-deferred basis, to a 401(k) plan is $15,500. It would take a generous employer to match that kind of contribution; there are probably very few employers that would do that. More typically an employer will match 100% of the first 2, 3, or 4 percent that an employee contributes, and perhaps 50 percent of the next 2, 3, or 4 percent contributed. To find out what your company offers, contact your human resources department.

Do you think you deserve a raise? Has your boss been slow in giving the raise you deserve? You can give yourself a raise, right now, using your employer’s funds. Go to your human resources department and ask for the paperwork to begin contributing to your 401(k) plan as soon as possible. Remember that the amount the employer contributes does not show on your W2’s as additional compensation; so it’s tax free.

When they were first set up, one of the stipulations for 401(k) plans was that the employer would not administer them. It was set up that way so that employers would not have access to the funds. Employers cannot tap into funds if times get hard; and if an employer goes bankrupt it does not affect the employee’s 401(k) plan.

You will notice that the literature you receive about your 401(k) plan isn’t from your employer, and does not bear your employer’s logo.

Unlike pension funds, 401(k) funds are protected in the event that your employer has to declare bankruptcy. Although you may be able to purchase your employer’s stock though your 401(k) plan, you will typically have many other choices as well. As in all stock purchases, you should have a diversity of stock, and not allow one stock to dominate your portfolio. Once again your human resources department will have information on how to make sure your 401(k) investments are appropriately allotted according to your investment goals.

No investment in the stock market could ever be absolutely safe. But employers don’t want to be blamed for 401(k) plans that have lost all value. So typically they will choose plan administrators who will offer relatively safe and well-proven investments. Typically the participant can choose between low-risk and high-risk investments, with even the high-risk investments being ones that are unlikely to suddenly bottom out.

The materials provided by your plan administrator should tell you which investment choices are safest. If you have any questions, contact your employers human resource department.

Your 401(k) is fully transferable, which means that you won’t lose it just because you switch jobs. Your 401(k) plan is administered by an independent third party and not your employer, so you can leave your existing 401(k) assets, with your current balance, right where it is. And even after you find a new employer, the 401(k) plan generally will remain active throughout your life.

Of course, you’ll want to check with your new employer about how new contributions can be made. Your new employer may well use a different plan administrator. In which case you would keep your original investment active but separate from your savings with the new company and their third party investment company. Or, if you prefer, you can “roll over” your plan into an Individual Retirement Account (IRA) administered by an independent financial institution, or into the new employer’s 401(k) plan.

An employee can also elect to have his or her plan cashed out; however, you should know that you’ll pay a high tax penalty if this is done: 10 percent of the amount cashed out. As soon as possible after switching jobs, you’ll want to find out about your new employers 401(k) plan. Contact the human resources department and discuss how to roll over your existing 401(k) plan, or any other options that may be available.

Although in general, the intention is for an employee to receive funds only after he or she is at least 59 ½ and ready to retire, many employers allow you to borrow from your plan. Naturally, you may not borrow the entire value, typically, you may be allowed to borrow something like half of the plan’s value, and you may be only permitted to have a certain number of outstanding loans.

Typically, the participant must pay a small servicing fee, but after that, the loan is repaid back to the plan with interest. As with the original contributions, the participant may be able to repay the loan through payroll deductions. Although these loans (or rather, the payments made to repay these loans) are not considered part of the adjusted gross income, neither are they deducted on a pre-tax basis. (The borrower, of course, already received this benefit when he or she made the original contributions to the plan.) Loans from a 401(k) plan can be another important benefit, if your employer offers it. And loans made for housing-- say for a down payment on a house -- may well have a longer repayment term.

Financial professional directly administers some 401k plans, but it is also common for employees to be allowed to make their own investment choices. In such cases, the employee becomes his or her own investor. As mentioned previously, an employee may be able to directly purchase the stock of his or her company through his or her contributions to the plan. But more typical than individual stocks are groups of stocks, say stocks representing small or mid-size companies. The participant may also be able to choose mutual funds, a secure investment that represents a diverse portfolio of bonds, equities and other securities. These are generally considered pretty safe, though when the market is doing well, they may not grow as quickly as higher-risk investments. As your human resource department will probably tell you, you should have a diverse range of investments.

Employers, or the third-party administrators of 401(k) plans, are required to make information accessible to employees. That’s why, once you begin to participate, your retirement IQ is probably going to increase. Once you begin making your contributions, you will begin to receive regular notifications, probably on a quarterly basis, about how your investments are performing.

Keep in mind; you are generally given several options for investing your contributions. Typically, these will be a mix of low-risk and high-risk investments. Low risk investments may include mutual funds and bonds; the higher risk (but potentially higher yielding) investments will typically be stocks.

In addition to regular performance reports, you’ll probably also receive many prospectuses for the stocks you chose to invest in. Regardless of the amount you contribute each week, you will have access to the same basic information as the most highly compensated employees.

Your company may also have a (secure) web page in which you, using the appropriate password, may be able to view your information, make investment choices, learn more about investing, etc. If so, use this resource wisely. You don’t want to make trades everyday- after all; your investments need time to grow. Nevertheless, you don’t want to ignore it. Its good to check up on your 401 (k) plan periodically and make sure that it is still growing. Many people don’t have any idea how much their 401(k) plans are worth, or how much money they’ll have when they retire.