What Is A 401k And Why Should I Use It?

So I got to thinking yesterday in writing about changing the funds around in my 401k, that people may or may not know the reasoning and benefits of a 401k; and I may be putting the cart before the horse.  So I figured it best to start at the ground floor… 

Many companies offer a 401K retirement plan.  In this plan you have the option to select the funds your company has chosen to represent your 401k and you then have the option to invest in them. The funds in the account can be invested in different stocks, bonds, mutual funds or other assets, and are not taxed on any capital gains, dividends or interest until their final withdrawal. Each employee can contribute up to a certain percentage of their pay which is up to 99% in my company, but I think I’ll hold off for now until I win the lottery.  A common percentage to shoot for is usually 15%. 

Your amount you contribute to your 401k is deducted directly from the salary before taxes into a 401K.  So if you make $1000.00 per month, the 401k money is taken out BEFORE Uncle Sam gets his piece.  So if you’ve elected to set aside 10% per month, that means that you get to put $100 in the 401k each month of your GROSS income.  Not the NET income, which is the amount you get to put in the bank after Uncle Sam has his go at it.  The flipside of it is that the $ gets taxed when you take it out, since it is NOT taxed when you put it in. 

Some employers match a certain percentage of your contribution, which is then invested.  My company matches up to 5%, so anything I put in above that is not matched.  So for the sake of numbers, if I make $100,000/year, 5% of that is $5,000.  If I am contributing 5%, that means my company will ALSO put in $5000.  You can hardly find that kind of return (100%) on your money anywhere.  and that is not including what the funds within it are doing.  You’re foolish not to contribute if your company is giving this kind of incentive to do so.

The funds can be withdrawn when you reach the age of 59 1/2. You can take it out before, but you’re going to pay a stiff penalty for early withdrawl.  

A 401K is an employer-sponsored retirement plan and is grouped into two categories.

1. Defined Benefit Plan: The employer promises to pay a defined amount to retirees who meet certain eligibility. It usually links the benefit to the amount of service and final average salary. Employees can either receive it as monthly retirement income or as lump sum on retirement.

2. Defined Contribution Plan: It is a contribution that an employer makes, and not the benefit that employee will receive at retirement. Since it is not a monthly income, an employee receives the amount in a current or deferred lump sum or annuity on leaving the company. Laws prohibit companies from utilizing the 401K money but can invest 401K money in stock fund. However, if your company goes bankrupt then you lose that money.

So yea, I understand WHAT it is now, but what’s the big deal, can’t I invest on my own?  Well, you COULD, but here are the teasers to getting in on the 401k pie:

• Tax advantage – you lower your taxable income when you contribute to a 401k.  So again, if you made $100,000/year, the 5% you’re contributing to your 401k plan wouldn’t be taxable, so you might fall into a lower tax bracket and pay less to the government.
• Employer match programs – 100% instant return on your money if your employer matches.
• Investment customization and flexibility – you can fiddle with your funds here without paying a penalty (most of the time) for moving funds like you would in a standard brokerage account.
• Portability – you can move this from company to company fairly easily.

Ok, so I know WHAT it is and WHY I can benefit from it, so HOW do I allocate the funds in my 401k?

Do not invest heavily in the stock of your employer’s stock heavily.  This is always a bad decision and a conflict of interest; ask Finance Is Personal or DaniWeb if you don’t take my word for it.  Instead, diversify your investments. Contribute the maximum tax deferred amount to your 401K each year.

There are a few different algorithms I’ve found out there for best allocating your 401k funds, but this seems to be a pretty good chart:

• Aggressive- For those with 35 or more years until retirement

50%-large cap stocks
15%-mid cap stocks
15%-bonds
10%-small cap stocks
10%-international stocks

• Moderate For those with 20 years until retirement

35%-large cap stocks
35%-bonds
10%-mid cap stocks
10%-small cap stocks
10%-international stocks

• Conservative-for those within 10 years of retirement

40%-bonds
30%-large cap stocks
10%-mid cap stocks
10%-international stocks
10%-cash

I can’t say enough how much my 401k has been good to me.  It’s a good place to start investing if you’ve never had any investment choices beforehand.  Most 401k plans from employees aren’t going to stick you with dumpy choices in their pool to choose; even if they do, you can always contact your HR representative and have them inquire about finding new funds if you’re unsatisfied.  The ol’ 401k can’t be beat if you’re just getting into the investment game for 3 reason:

1.  You’re getting instant return on your money if your company matches.
2.  You’re not having to worry about playing risky in the stock market because they’re mutual funds, not individual stocks.  Therefore, they’re far less volatile.
3.  98% of businesses today use a 401k or 403b plan.  They’re everywhere, so there really is no reason NOT to join in. 

Even if you can only contribute 1% of your salary to a 401k plan, do it.  Compounding interest is the most exciting thing about investing – just look at what 1% of $50000 will grow to in 40 years (click the graph):

Yep, that says $250,000 – so why not start today? 

Filed Under: 401K • advice • Investing • Net Worth • Retirement