How 401k Plans Work Excerpts from http://money.howstuffworks.com/personal-finance/retirement-planning/401k.htm 401(k) plans are part of a family of retirement plans known as defined contribution plans. Other defined contribution plans include profit sharing plans, IRAs and Simple IRAs, SEPs, and money purchase plans. They are called "defined contribution plans" because the amount that is contributed is defined either by the employee (a.k.a. the participant) or the employer. When you participate in a 401(k) plan, you tell your employer how much money you want to go into the account. You can usually put up to 15 percent of your salary into the account each month, but the employer has the right to limit that amount. It might be worth your while to rally for a higher limit if it isn't as high as you would like it to be. The money you contribute comes out of your check before taxes are calculated, and more importantly, before you ever have a chance to get your hands on it. That makes the 401(k) one of the most painless ways to save for retirement. If you're lucky, your employer will match a portion of your contribution. Your employer wants you to participate in the plan because of compliance issues we'll talk about later. The matched amount they offer (the free money part) is your incentive to participate. The money is given to a third party administrator who invests it in mutual funds, bonds, money market accounts, etc. They don't determine the mix of investments -- you do that. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take. How safe is your money? What if your employer declares bankruptcy? How do you know your money is safe? The Employment Retirement Income Security Act (ERISA) that was passed in 1974 includes regulations that protect your retirement income. It requires that all 401(k) deposits be held in 1
custodial accounts in order to keep your money safe in the event that something happens to your employer. It also sets requirements that your employer must follow, such as sending you regular account statements, providing easy access to your account, and maintaining compliance so that the plan is fair for everyone in the company. It also requires your employer to provide you with educational materials about the investment opportunities within your plan. 401(k) vs. Stocks Why would you be better off contributing to a 401(k) plan than you would be, say, investing in stocks on your own? After all, with your own investments at least you're not penalized when you sell them. There are several advantages to a 401(k) over your own investments. Of course, that doesn't mean you shouldn't do both. It is always a smart move to diversify (or spread out) your overall financial investments. The primary advantages to a 401(k) are that the money is contributed before it is taxed and your employer may be matching your contribution with company money. There are other advantages, but let's talk about the two heavy hitters first. What does "pre-tax" really mean? Let's do the math to see the advantage of pre-tax saving. For example, you may decide you want to put $200 into your account each month. Assume that, prior to starting your 401(k), you were bringing home $2,000 per month pre-tax, and $1,440 post-tax (paying $560 in tax for a 28- percent tax bracket). Because the $200 comes out pre-tax, that means you are taxed on $1,800 (paying $504 in tax), so your post-tax income is $1,296. In other words, you are paying $200 into your 401(k), but your take-home pay only goes down by $144. You just saved $56 per month! In addition to reducing the amount of tax you pay on your salary, you'll also defer tax on earnings from your 401(k)'s investments until retirement. At that point, you will probably be in a lower tax bracket anyway. You may also be living in a state that has no state income tax. (FYI, those states are: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Tennessee and New Hampshire only tax dividends and interest income.) It may not seem like a big deal now, but try out this Taxed and Non-taxed Compounding Calculator to see how much this can make a difference over the years. Free Money Let's talk about that free money from your employer. Although they aren't required to, many employers match a percentage of what their employees contribute to their 401(k) accounts. The catch is that they typically don't put anything in unless you do. Another thing to remember about the contributions your employer makes is that, although the total annual amount they can contribute is limited by the IRS, that amount doesn't count toward the total annual amount you can contribute ($15,000 in 2006). There is an overall limit on how much can go into your 401(k) account each year. The limit for an individual in 2012 is $17,000. The total combined amount that can be contributed by both employees and their employers for 2012 is set at $50,000. 2
Deciding Where to Invest A typical 401(k) plan may offer 20 or more investment choices to its employees, including: Stock mutual funds Bond mutual funds Stable value accounts Money market accounts How Roth IRA Investments Work Excerpts from http://money.howstuffworks.com/personal-finance/retirement-planning/roth-ira.htm A Roth IRA is similar to a savings account, but unlike a savings account, you invest this money to generate a sizable profit. That profit is then reinvested in the Roth IRA until the maturity date of the account. Because you invest your money into a Roth IRA after taxes, you don't have to pay taxes on the earnings upon withdrawal of the funds at or after the maturity date. This is different from other types of IRAs, 401(k), or 403(b) where you will pay taxes when you withdraw funds. Roth IRAs offer flexibility to the contributor, as funds can be withdrawn prior to maturity without being penalized, (once you meet certain criteria). The Roth IRA was born as a result of the Taxpayer Relief Act of 1997. Named for the late Senator William V. Roth Jr., the Roth IRA was developed not only to help middle-class America save for retirement, but also to offer a savings plan that could be used to purchase a primary residence, pay for medical expenses, or fund a child's college education. The Roth IRA can be set up at any bank or brokerage firm, and its terms are extremely flexible. Roth IRAs allow for early withdrawal of your original contribution (not the earnings) without penalties after a 5-year waiting period. The earnings generated from the original Roth IRA contribution can also be withdrawn early, but the profit is subject to penalties. The money invested in a Roth IRA has already been taxed, so any return you earn on your Roth IRA investments won't be taxed, as long as you wait until you're at least age 59 ½ to withdraw your profits. On the other hand, contributions to a traditional IRA are taxed as income upon withdrawal. Just remember, a traditional IRA is tax deductible, but a Roth IRA isn't. The beauty of the IRA, in general, is that you're free to invest the money in your IRA however you chose. Some common Roth IRA investment options are common stocks, index funds, bonds, certificates of deposit (CDs) and REITs (real estate investment trusts). The flexibility that comes with being able to invest your Roth IRA as you choose, as well as being able to withdraw funds early or leave them long after your 71st birthday, make the Roth IRA immensely popular. 3
Roth IRA Contributions: What's Age Got To Do With It? Younger people have an advantage when investing in a Roth individual retireme nt account (IRA) over older Americans who have not taken advantage of this retirement opportunity. (By the way, you don't have to be an American citizen to set up a Roth IRA, but the funds you contribute to a Roth IRA must be earned from United States employment. If you're not an American citizen, you must meet certain guidelines to participate in a Roth IRA.) Think about it-- a 25-year-old can contribute a maximum of $5,000 annually to a Roth IRA. This has the potential to grow significantly over the years. If that same 25-year-old only invested $5,000 one time and made 8 percent annually on the money, he or she would have $7,346.63 after 5 years. Here is what the money would look like over a 10-year period of earning percent interest on an initial investment of $5,000: $5,000.00 @ 8.0% = $5,400.00 $5,400.00 @ 8.0% = $5,832.00 $5,832.00 @ 8.0% = $6,298.56 $6,298.56 @ 8.0% = $6,802.44 $6,802.44 @ 8.0% = $7,346.63 $7,346.63 @ 8.0% = $7,934.36 $7,934.36 @ 8.0% = $8,569.11 $8,569.11 @ 8.0% = $9,254.64 $9,254.64 @ 8.0% = $9,995.01 $9,995.01 @ 8.0% = $10,794.61 It seems simple, doesn't it? Imagine how much that initial $5,000 investment will make over the 34 years it will take to reach maturity. Oh, the power of compounded interest! Another benefit of contributing to a Roth IRA is that there's no mandatory withdrawal date. This is very important when looking at investment options for yourself. Most retirement investment programs require you to begin making withdrawals on your investment when you reach 70 ½ years of age. The Roth IRA has no such requirement. In fact, you can contribute to your Roth IRA with no intention of ever making withdrawals, and your beneficiaries can inherit the account with no penalties attached. Just imagine how much the 25-year-old's initial $5,000 Roth IRA investment would have grown after 60 years of earning potential. Qualifications for Roth IRA Participation Like all good things, there are certain limitations placed on the Roth IRA. This type of IRA was developed specifically with middle-class Americans in mind, so there are obviously income restrictions and contribution limitations, but the expected age limits may surprise you. Unfortunately, if you're single and have an adjusted gross income (AGI) of $110,000 or more, or if you're married and filing your taxes jointly and have an AGI of $160,000 or higher, you're not eligible to contribute to a Roth IRA. Think about investing those six-figure salaries into other high-return retirement options. Another income rule with Roth IRAs is that you must earn a minimum annual income equal to what you contribute to your Roth IRA. If you earn only $3,000 a year, you can contribute no more than $3,000 annually to your Roth IRA. Everyone else can contribute a set amount, determined by age, annually. In 2012 an individual can contribute $6,500 to a Roth IRA. The hairy thing about a traditional IRA, like many other retirement plans, is that you're required to start making withdrawals when you turn 70 ½. This can stifle some retirement hopes, since most Americans will work well into traditional retirement age and hope to continue to generate a return on retirement investment options. The good news, however, is that a Roth IRA allows you to contribute as long as you'd like. There's no set withdrawal date. In fact, you can leave your 4
money in this tax-sheltered account as an inheritance for your heirs, with no intention of ever using it for yourself. This is a great benefit for your heirs, since there's no penalty to a beneficiary who inherits a Roth IRA. Your beneficiary can just keep the Roth IRA account and continue to grow it, or he or she can withdraw funds, all tax-free. Limitations/Restrictions to Roth IRA First of all, if you do have an employer-sponsored retirement program, such as a 401(k) or a 403(b), and your employer matches your contributions, you should always use this investment opportunity first. Never pass up an opportunity to receive free money from your employer! Investing in a Roth IRA should be used as a secondary investment plan for retirement, after you've reached the maximum contribution amount with your employer-sponsored retirement program. Secondly, the maximum annual contribution you can make to a Roth IRA may be substantial for some people, but not much at all for other people. It's all relative to your lifestyle. While most 401(k) programs have an annual maximum contribution amount of 12 percent of your adjusted gross income (your taxable income), the set Roth IRA contribution amount of $5,000 or $6,000 annually can be significantly less than that. For example, a single 33-year-old guy earning $70,000 a year can only contribute just over 7 percent of his annual salary to a Roth IRA. Fortunately, a Roth IRA can be set up in addition to other retirement accounts. Another drawback of the Roth IRA is that contributions to it aren't tax- deductible. For many people considering opening a Roth IRA, this is a very important factor. However, the benefit of no tax on Roth IRA earnings upon withdrawal at maturity date tends to outweigh the benefits of having a tax deduction. Here are two more important things you should know about a Roth IRA. 1. Keep in mind the current Roth IRA contribution limits. If you go over the maximum contribution limit for the year, you must withdraw the excess funds prior to filing your income taxes for that year. If you don't withdraw these funds in time, you will be subject to a 6 percent tax on the excess funds. 2. Be aware of Roth IRA income limits. If your annual income gradually increases over the years and you find yourself at the maximum income level, you're no longer eligible to contribute to your Roth IRA. You can leave the money in your Roth IRA as is and watch it grow over time while you invest your big, fat salary into other retirement plans. To find the best Roth IRA and other retirement plans for you, consult a financial planner. 5