401 K Plans

The Joy of Tax Free Investing

If you work for an employer that offers a 401 K plan, you should seriously consider contributing as much as you can to it, especially if the employer is making matching contributions.

There are several advantages to a 401 K plan. First, the money is taken out of your paycheck before you have a chance to get your hands on it. This is a big plus.

Second, the contribution limits can be much higher than an IRA, depending on your salary and the terms of the plan. Usually you are allowed to contribute up to 10% of your salary up to a certain limit. In 2005 the limit is $14,000, rising to $15,000 next year. If you’re over fifty, you’re allowed extra makeup contributions of $4000 in 2005 and $5000 in 2006. [There are some complex IRS regulations that apply including income limits, so ask your employer’s benefit department to determine how much you can put in.]

Third, the money is invested pre-tax. In other words, you don’t pay Social Security, Medicare or any other withholding tax on this money. What this means is that a $250 monthly contribution actually costs you (depending on tax rate, etc) somewhere in the area of $190 - $225. Investments to IRA’s are after tax: $250 is $250.

Fourth, if the employer matches a portion of your contribution, you have a built in return on your money. For example, if your employer matches half your contribution up to 6% of your salary, which is not unusual at large companies, and you make $30,000 a year, you could invest up to $3000 a year and your employer would contribute an additional $900. You're starting off with a built in 30% return. [The employer’s contribution alone will be worth about $220,000 at age 65, if you start your 401 K at age 32 and never get a raise.]

There are some downsides to 401 K plans. Among them are: you might be limited in your investment options, although most plans will offer two or three types of investments: your employer’s contribution might not vest immediately, in other words, if you’re fired or quit before a certain time period, typically three to seven years, you won’t be able to keep the employer’s contribution: the employer might make his contribution in the form of its stock, instead of cash (cash is better) or might limit your investment to company stock only.

In the last circumstance, you might want to take a pass. Too many companies have gone under dragging their employees’ savings along with them. I know this from my own experience. I worked for a company in pre-401 K times, which offered a savings plan that allowed only investment in the company stock. I only had a small amount invested and wasn’t hurt badly. Lifelong employees who had everything in the plan saw their retirement go down the tubes.

It’s better to diversify your investments. An investment in an S&P 500 Index Fund is diverse enough.

Many employers are using 401 K plans in lieu of offering a retirement plan of their own. They are transferring the risk of meeting investment goals from themselves to their employees. However, a lot of financial experts think that employees are too timid with their investments.

I agree that you should put a good portion of your 401 K money into more aggressive investments, which fluctuate in value more, but which generally have a higher rate of return. This is especially true if you are young.

Just invest the money and forget about it.

Finally these plans are not insured like some pension funds. But that is true of a lot of pension funds as well.

Among some of the other benefits of 401 K plans are that they are portable. If you leave your job, you don’t lose your investment, like you might lose your pension. Depending on the plan, you are usually allowed to leave your money in the employers plan if you wish, roll it over into another employer’s 401 K or into an IRA.

Also some plans allow you to borrow from them. You are borrowing from yourself and repaying yourself with interest. You should not do this if your job is in jeopardy, since you only have a short time to repay it if you’re laid off or you will face IRS penalties.

Also if you have to stop contributing to the plan and miss out on your employer’s contribution, this can turn out to be a very expensive loan indeed. If you forego the employer’s contribution for 5 years from age 30 to 35, the lost contributions and the money you would have earned on them, will deprive you of roughly $95,000 at age 65.

Only borrow: a) when absolutely necessary; and b) when you can keep up your contributions in addition to the loan repayments. Ideally, just leave the money alone. Remember you can’t get financial aid for retirement.

Try to forget you even have any money invested in your 401 K plan for at least the first five or ten years. Don’t use a 401 K plan as a sort of savings account that you withdraw from every couple of years. The money you lose from not allowing the money to continue to grow in a tax free environment is enormous.

And yes, you can contribute to both a 401 K and an IRA each year.

Unlike a Roth IRA, this money is taxable when you withdraw it. But if you have enough of it, what harm is there is paying a little tax?

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September 2006 Update: 401 K Rules Change

There have been some changes made to 401 K plans recently.

One is the government's effort to encourage participation. It used to be you had to "opt-in" to your employers plan to be included. Now you have to "opt-out". Otherwise your employer will enroll you at a certain minimum level.

The more dramatic change is the "Roth 401 K" plan. Until this change, money you - and your employer - paid into your account was not taxable. So if you were in the 20% tax bracket, a $100 contribution "cost" you only $80 because you were paying with pre-tax dollars.

A Roth 401 K is like a Roth IRA. You get no deduction for your contributions, but your money grows tax free - as it does in a regular 401 K plan. The major benefit is that all withdrawals are tax free. Like Roth IRA's the money has to have been in the account for a minimum of five years before this tax break kicks in.

Whether it is worth it to switch over to a Roth 401K plan is more complicated that the IRA switch. You are dealing with higher contribution levels in most cases and the present tax benefit makes a 401 K an attractive investment. If your contribution remains the same, the after tax cost of the investment is going to go up.

Your assumptions about tax rates when you retire and how close you are to retirement come into play. So before you jump into a Roth 401K plan, sit down with a CPA or Certified Financial Planner to see if the change makes financial sense in your present circumstance.

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