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401k Retirement Plan Basics
June 2004

If your employer offers a 401k retirement plan, take advantage of it. You get some nice benefits if you do. Participating in your employer 401k plan helps you save for retirement, get an instant return on your money (maybe 50% - 100% depending on your employer's plan), lower your taxes and not pay a dime of taxes while you are saving! If you don't choose to invest in your employers 401k you are leaving money on the table! Here's why...

When you enroll in a 401k retirement plan, your employer will typically match a certain percentage of the amount you contribute. For instance, if you put in a dollar and your company offers a 50% match, that means 50 cents is invested in your 401k account by your company. There's your 50% return. Some employers offer higher matching contributions. Mine is generous enough to match dollar for dollar up to 3% of my salary. And that brings us to the next concept you need to understand.

The matching funds are up to a certain percent of your salary. Let's say you earn $50,000 a year. If your employer matches dollar for dollar up to 5% of your salary, that means they will contribute $2,500 into your account. ($50,000 x .05 = $2,500) You just gave yourself a 5% raise!

Sound good? It keeps getting better. Using our example above and you contribute 5% of your salary ($2,500) you are also reducing your taxable income by that exact amount. When you pay your taxes, your taxable income is $47,500 ($50,000 - $2,500).

The advantages continue. The entire amount in your 401k is allowed to grow, year after year without paying a dime of taxes. In a regular investment account, you would have to pay taxes on any dividends or capital gains that you earned. The government stays away from your account and allows it to grow without taking 1 penny for taxes. This can lead to huge differences in the amount in your account when you reach retirement because of the power of compounding.

Other 401k retirement plan considerations

What happens if you leave your employer? Going back to our earlier example, a total of $5,000 ($2,500 was yours and $2,500 was your employer's) was invested in your 401k retirement plan. That's your money right? Well, not exactly. The money that you put in, and the investment returns that it earned are entirely yours. However, the amount the employer put in for you may not be yours. This is what is called "vesting".

Employer 401k retirement plans have vesting schedules which stipulate what amount of the employer match is yours if you leave the company, based on how long you were an employee. An example would be 25% after the first year, then 50%, 75% and 100% after the 4th year.

What are your employer's 401k investment options? One caveat is if the 401k is completely invested in company stock. Remember Enron? Those employees held their 401k's in Enron stock and many of them had their entire retirement accounts completely wiped out. Make sure you have the option to invest in mutual funds which diversify your investment. Your employer stock and company may be a great investment, but never put your eggs in one basket.

What are the 401k contribution limits? In 2004 the limit was $13,000. The limits in 2005 and 2006 are $14,000 and $15,000 respectively. After 2006, the limits are increased by $500 increments.

Where can I find 401k calculators? Below are some links to test different scenarios that take into such factors as account employer match, contribution limits, investment returns and how long until retirement.

  1. Bankrate.com 401k retirement calculator
  2. Bloomberg 401k calculator
  3. 401k Help Center - You will find their 401k calculators towards the bottom right of the page.

 

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