401(k) plans

401(k) plans

Variations in 401(k) plans

As you can see there's a variety of different retirement accounts for various organizations. Even among 401(k) plans there's a wide variation among plans. The IRS lays down general guidelines that all 401(k) plans must follow, but many details are left up to the company sponsoring the plan.

For example, the IRS places a cap on the amount of money a worker can save pre-tax in a 401(k) plan. This amount is currently set at about $9,500, and is indexed to go up with inflation.

However the IRS doesn't specify if an employer has to provide matching contributions, and the plan administrator decides if workers can borrow against their 401(k) accounts.

So I can't go into the details for each particular plan, but I'll try to describe the most important regulations and give you a feeling of what most plans allow.

If your company's plan isn't as good as other plans, see your benefits department. They generally want to keep their people happy, and many good changes can be done at little or no cost.

How 401(k)s help you build assets

By the way, the term 401(k) comes from the section of the Internal Revenue Code which defines this kind of retirement account.

The nice thing about 401(k) savings plans is they allow you to either take all of your salary now, and pay taxes on it, or you can stash some of it into a tax-deferred account.

Reducing your take home pay through the account provides you with two benefits. First, it reduces your taxes immediately. The amount saved is not included in your taxable income, although it is subject to Social Security taxes. Second, any earnings in the account are not taxed until withdrawal, usually in retirement.

This second part, when combined with compounding, offers tremendous growth potential. Recall our earlier discussion of compounding. Remember that increasing your return by a few percent can easily increase the size of your account by 50 percent or more after twenty years.

Tax-deferred earnings help to raise your rate of return. Let's say you invest in stocks which historically have returned 10 percent a year. Also assume you're in the 28 percent marginal tax bracket, which is the middle-class tax bracket.

If you had invested in a taxable account, 28 percent of your earnings would go to the federal government. Your after-tax return would be reduced from 10 percent to about 7 percent. This will dramatically reduce your total nest egg by the time you retire.

Paying taxes later probably won't hurt you

Under a tax-deferred account, you'll eventually have to pay taxes on the money when you withdraw it from the account. But paying taxes later, rather than sooner, is better for three reasons.

First, early tax deferral allows you to build a much larger amount of money. Because of the nature of compound growth, having more money early helps you tremendously. Even after you pay taxes as you withdraw the money in retirement, you will undoubtedly have more money than if you saved outside a retirement account.

Second, you can leave money in the retirement account almost as long as you want. You're required to start withdrawals after age 70.5, but you can leave most of the money in there. It will continue to grow, untaxed, at a higher rate.

Finally, if you need to make withdrawals to provide income while retired, you can probably do so at a lower tax rate. While you're working, your income is high, and your need for money is also high. There's kids to feed, mortgage payments and college tuition.

In retirement, however, your mortgage may be paid off and you'll only need money for daily living expenses.

So it's not uncommon for people to be in the 28 percent bracket while working, and the 15 percent bracket while withdrawing money from their account in retirement. And they're still living comfortably in the 15 percent bracket because they don't have to pay for things like a home or college tuition.

401(k) matching programs - your best investment

So 401(k) accounts offer great tax savings, but they also offer something no other investment can beat : a guaranteed, immediate return on investment of from 50 to 100 percent.

Over 80 percent of companies that offer 401(k) plans also offer a matching program. Under a matching program, you get free money from your employer just by saving for your retirement.

The more you save, the more money your employer chips in, up to a limit. If this isn't an incentive to save I don't know what is.

A typical matching program works like this. Suppose you're making $30,000 a year pre-tax and you decide to save $3,000 into your 401(k) account. This alone will reduce your taxable salary to $27,000 and save you maybe $1,000 in taxes this year.

In addition, let's say your employer kicks in 50 cents for every dollar you save, so your account grows by an additional $1,500 dollars instantly. The $1,500 that the employer contributes does, however, have a few strings attached.

The employer's contribution is subject to vesting rules, and you'll have to pay taxes on it eventually when you withdraw it maybe 20 years later. Still, you get an immediate, risk-free return on investment of 50 percent.

This is why retirement plans should be your first place for saving money. And I don't care if your stock broker has found the next Microsoft. It's doubtful you'll be able to beat a retirement plan with matching contributions.

401(k), 403(b) etc. for large employers

401(k), 403(b), 457, and Federal Thrift Savings Plans are primarily used by larger corporations, nonprofits, local governments and the federal government, respectively. However, smaller companies often can't afford to set up 401(k) plans because of the complexity of administering them.

For smaller businesses, there are three main options for retirement plans. The first is a Keogh plan, the second is called a Simplified Employee Pension or SEP, and the third is called a SIMPLE plan.