Last week, we talked about the use of IRA plans as part of your retirement program. I told you then that the 401(k) plan was another alternate tax-shielding plan and that it was one that you should investigate carefully because of the allowance of a much larger contribution each year. That allowance can make a substantial difference in the money available at retirement time.
But, I want to add quickly, that this type of plan also has some limitations that, depending on your circumstances, may not make 401(k)s your cup of tea. Some of the rules are pages long and really "fuzzy."
So, today I will cover the basics of the 401(k) plans. This won't be a highly detailed discussion, just one that will give you most of the basics to help you make decisions about whether you should look into 401(k)s more closely or not. That said, here goes.
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Unlike the IRA, 401(k) tax-sheltered programs are not opened by individuals, but by a company. The employee funds the plan — often the employer will opt to add some funding, also — but the return at the end, retirement, is entirely dependent on the total dollars put in and the investment return the plan earned over the years you owned it before retirement.
All requirements for you to become a part of the employer plan are controlled by IRS approved rules and the rules to participate can be lenient or restrictive, depending on what the original plan submitted to the IRS looked like.
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If the employer does fund part of the plan for you, be sure you are very clear about how this additional funding is done. In most cases, you will likely find that for each dollar you contribute, the employer will add some percentage of your contribution in the form of cash or company stock.
I have seen them as skimpy as $.10 for each dollar you put in to as high as a dollar for dollar match. (Anybody out there ever hear of a larger than dollar for dollar contribution by an employer? Just curious.)
If the matching is large, I strongly recommend that you add just as many dollars to your plan as you can afford. It is the best way I know to really grow your retirement fund. Nothing else compares to it.
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One caution, however. I would be very wary if all or a very large part of the company contribution went to buy only company stock. Remember Enron? Need I say more? Now, most companies are not Enron's, but the caution is just to be sure you really have a good handle on your company's financial and growth prospects.
In addition, be sure you have some history about the manager of the plan funds and the type of investment diversification that is part of the investment plans objective. (See, I told you there were some fuzzy parts to using the 401(k)). It is important that you don't put most of your plan funds in one stock or one type of industry. It is like putting all your marbles in one basket, you might say, a very poor practice.
Most plans will detail a list of the type of investments they will allow in the plan. Many will allow you to decide just how you want to invest your funds.
I like this approach best, of course. It allows you complete control over how you integrate your total retirement plan with the funds in the 401(k).
Most plans (again, not all of them) will usually allow investments in stock mutual funds, bond mutual funds, Treasury bonds, money market funds, stocks, some annuity plans, Treasury bills, and CDs. This is not meant to be a complete list, but the good plans will typically allow most of those I just mentioned.
As with any investment plan, there are administrative expenses to be considered. Typically, these are of little import to your program for retirement, as most of the investments will be held for a very long period of time, meaning few trades (low commission costs) generally and, thus, a low overall expense.
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However, be alert to the other significant fee, the management fee for the plan. Compare it to some of the no-load funds out there and some of the other mutual funds to see how it compares. If the plan's fees are high in comparison, I would, again, consider keeping only a limited amount of your total retirement funds in such a plan.
Like the IRAs we discussed last week, there are allowances for early withdrawal of tax-sheltered fund from the 401(k) so long as the IRS definition of a "hardship" is met (they require an "immediate and heavy financial need" to permit a no penalty early withdrawal).
Typically, such things as funds needed for financial hardship include employment termination related debt, disability of the plan owner, or in the event of the death of the plan holder, an allowance that beneficiaries can withdraw the funds at once without a penalty.
With regard to the hardship issue, the IRS is really quite specific (and long-winded) about what is a hardship, so I will not go into all the details here. However, here are the basics you can claim to get a no penalty withdrawal:
Medical expenses not covered by your insurance;
Funeral expenses for family members;
Some home repairs (usually due to some sort of major damage like fire, hurricane, etc).;
Secondary education costs incurred in the last 12 months (see, I told you they are very specific); and
Home purchase costs (not mortgage payments however, unless the home is facing foreclosure).
Any other withdrawal from the plan by its owner will generally cost them a 10 percent penalty (except, of course, for funds withdrawn after age 59 1/2 when taken as part of the normal retirement plan withdrawal).
There is one other way to take money out of the plan without calling it a withdrawal, according to the IRS. That is when you take a "loan" from the plan. It works like this:
First, the employer's plan must state that loans are allowed by plan participants;
Second, the maximum amount allowed to be borrowed is up to 50 percent of the vested balance in the plan, with a minimum of $1,000. There is also a maximum of $50,000.
Payments to repay the loan must come from the salary of the plan owner (only post-tax dollar allowed in the payment amount) and an interest charge is added to the loan payment each time a payment is made.
Oh yes, and if you decide to quit your job or and your company lets you go for any reason, the loan must be paid off in full or the loan becomes a withdrawal that will cost you a 10 percent penalty. No wiggle room here!
Another point to be checked out carefully is how you can take the funds out of the 401(k) at retirement. Be advised that you will be allowed only the ways the plan was authorized with the IRS when the plan was approved (or as it might have been amended over time).
Generally, there are three ways that funds are allowed to be paid out to you. The simple one is a straight out lump sum payment. Second, is an installment program, and third, is to use the funds to purchase an annuity.
Each of these has tax consequences, and I am no tax expert. But, I am told the annuity and the installment are the easiest on the tax hit over time, while the lump sum usually hits your pocketbook the hardest. But, as I say, check with a tax specialist to have them tell you which method looks best for your particular situation.
One more important thought here. If your company has contributed to your plan in the form of stock in the company, they will generally determine, at the time of the distribution, the stock price value per share of the stock distribution made.
Additionally, you will not need to pay any tax on this stock until you actually sell it, a potential plus if your company is growing and you would like to hold the stock for a longer period of time than being forced at retirement to sell it. Again, I would advise you to see a good tax specialist about the implication of this situation on your pocketbook.
Finally, the distribution rules that govern you when you are retired are also quite specific. First, you pay taxes on any money paid out, except for any after tax contributions paid out to you as part of your retirement plan and for payments from a Roth IRA (see last week's column in the MoneyNews.com).
There is another rule that kicks in after 70 1/2 for both IRA and 401(k) owners (except Roth IRAs, again). You must begin to withdraw funds at a specific dollar rate each year (the plan manager's usually send you a letter in January of each year to tell you the amount you are required to withdraw).
The amount is based on life expectancy tables provided by the IRS. One minor exception here, however. If you are still working at age 70 1/2 (there really are folks that just like to work!), you may not be required to abide by the minimum withdrawal rules in some cases. Again, see the rules for your plan for details.
Okay, you have been so very patient, now I'll get to our last and most important point. Just how much can you put in your plan every year?
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Currently, the limit of pre-tax dollars is $15,500 for this year. This amount will continue to change each year, under a new law, to index for inflation. This means Congress doesn't have to take up a bill to adjust the levels every 4-5 years (I wonder what congressman finally figured that one out after all these years?).
There is also a special rule covering folks that are 50 years of age or more. They are allowed to add an additional $5,000 each year of pre-tax dollars to, as they call it, "catch-up" for years where the contribution levels allowed were lower. They are approaching retirement soon and Congress felt they could use the help, I suppose.
There are rules that will adjust this level up each year, also, but see the IRS rules for that, as they are too long to include here. And here is an interesting rule. If you work for the government, you are not allowed to have a 401(k). Instead, there is a special plan rule called the 457(g) rule that allows a 401(k) like plan for them. And yes, the rules are a bit better for them. Wonder why?
There are also rules for what the IRS calls "highly compensated" employees, but, again, see the rules, which are too long for this article.
And one final kicker for us regular folk: If your company adds funds to your 401(k), there is a contribution limit of a total of $45,000 per year this year (inflation adjusted each year, also) or an amount not to exceed the employee's regular income per year.
This can be a HUGE PLUS! This kicker can literally DOUBLE the contribution of pre-tax dollars to your plan. This is one to check out carefully with your employer if they do contribute. A potential bonanza!!
Well, that's about it for today. As I said up-front, I didn't try to cover every base in this column about 401(k) plans, but you will find 90-95 percent of the most important rules mentioned here. Again, do check the rules of your company's plan with your employer's plan representative (most companies have someone that spends all their time helping employees with their 401(k) retirement plans).
So for now, here is hoping you have a good investment week coming up. Meanwhile, you keep touch. I do! See you next week.
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