How 401 k Plans Work

By: Lee Ann Obringer

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  • Free money from your employer
  • Lower taxable income






What makes a 401(k) different?




Here's what the overall process looks like:



How safe is your money?




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, they typically don't put anything in unless you do. (We'll talk about "Safe Harbor" options later -- these can require your employer to contribute to every eligible employee.) If you aren't participating in the program, you're basically leaving money lying around for someone else to pick up. It's like finding a $20 bill at the amusement park and leaving it lying on the ground.

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 total for 2006 is $44,000 or 100 percent of your annual salary, whichever is less. This limit is referred to as the 415 limit (also named after the Internal Revenue Code that established it).

A small downside to the employer contribution is that there may be a vesting schedule. Vesting means that there is usually a tiered schedule for when money the employer contributes to your account is actually yours. For example, your employer may have a three-year vesting schedule that increases your ownership of the money by one-third each year. After three years, the money is all yours and all future contributions are 100-percent yours.


Borrowing From Your Account

You may be thinking that you really can't afford to put 15 percent of your salary into an account you won't be able to touch until you retire. But in some 401(k) plans, you can borrow from your account in the event of an emergency. You'll pay interest, but you are paying it to yourself. (There can be some disadvantages that go along with the advantages of taking out a loan against your 401(k).)

And finally, if you're thinking about just opening an IRA (which is still a smart thing to do), you might take note that you can only contribute $4,000 annually to an IRA (in 2006 -- this will increase to $5,000 by 2008), while your annual contribution to the 401(k) can be up to $11,000.


Changing jobs

What if you change jobs? Does that mean you have to pay the tax and penalty in order to keep your money? No. You can either:

  • Keep your money in your former employer's plan
  • Roll the money over into a new 401(k) plan or IRA You do have the option of cashing out, but unless you are 59.5 you will have to pay the tax and the 10-percent penalty to the IRS.

If you decide to roll it over into another 401(k) or IRA, MAKE SURE you don't let the check be written to you. The check has to be written to go directly into the new account. There is no grace period for putting the money into the new account. If it does come to you rather than the new account, you'll be charged the tax and the 10-percent fine.

If you choose to keep your money in your former employer's plan, then there are also a couple of requirements. First, you have to have a fully vested total of at least $5,000 in your account, and second, you have to be under the plan's normal retirement age (usually 65).


How Much to Contribute

So, how much should you be putting into your 401(k) account? That partly depends on what your employer will let you contribute. Usually you can put in up to 15 percent of your annual salary. If your employer doesn't allow that much, then you can always lobby for a higher percentage. It may take a while and you'll need the support of co-workers, but it would be worth it. For 2006, the IRS limits the total annual contributions (both your contributions and the amount your employer matches) to 100 percent of your salary or $44,000, whichever is less.

Things to consider...

There are several things to take into consideration before you settle on an amount to contribute each month. First, how is the economy right now? Is your job stable? Are there are lot of layoffs going on in your industry? If that's the case, then it would be prudent to have a little more money in a more accessible savings account or other financial account. The general rule of thumb is that you want to have at least three months of living expenses in an accessible account at all times, and preferably six months. This is particularly true in tougher economic times.


But, what if everything is going swimmingly, your job is secure, and you don't have any large upcoming financial needs (like kids going to college)? In that case, you should probably be a little more aggressive with your contributions. Plan out your needs for the year and make a commitment to yourself about how much money you want to save. It will all boil down to how much money you can realistically do without. Extravagant vacations, luxury cars... do you really need them? Or, it may just be a matter of how much money you can do without and still be able to pay all of your bills.

Whatever the situation, sit down and figure out a budget that includes a set amount of money going to a 401(k). There are some great budget calculators available on the Internet that will help make sure you don't miss anything when you set up your budget. Use this investment calculator to find out how much difference $50 per month will make over 20 years, or $100 will make over 10 years.

Overall, if you're young, have a secure job, and have no big money needs coming up, then it makes sense to put as much into your 401(k) account as your employer will allow you.

Don't forget raises...

The 401(k) plan is so easy that you may even forget you're putting money into it. Whatever you do, don't forget to increase the amount you put in when you get a pay raise (or even if you have more income from some other source). In some cases, your employer may be transferring your contribution as a percentage of your salary. If that's the case, then increases in your salary will automatically increase your 401(k) contribution. If your employer is putting a flat amount into your account, however, you'll need to make sure you tell your employer to increase it and by what amount.


Deciding Where to Invest

So far, all of this 401(k) decision-making has been pretty easy. Now it is time for the fun part -- deciding exactly how and where you want to invest your hard-earned dollars.

Your typical 401(k) plan may offer 20 or more investment choices, including:



­What are the differences? How should you split up your dollars to get the most bang? Most likely, your plan administrator won't be advising you on exactly where to invest. It's too much of a liability. First, let's go over what all of the options listed above actually are.

Money-market accounts and stable value accounts usually consist of certificates of deposit and U.S. Treasury securities. They are very secure, and offer small but steady growth.

Bond mutual funds are pooled amounts of money invested in bonds. Bonds are basically IOUs that companies or governments issue. Bonds are paid back with interest that is usually a fixed percentage of the amount purchased. When a bond within the mutual fund reaches maturity, the proceeds are used to purchase different bonds for the portfolio.

Stock mutual funds are portfolios of company stocks. When you buy stocks, you are buying a small part of the company. Stock mutual funds, like bond mutual funds, are managed by a professional money manager. Each company's stock within the portfolio has a different value that will fluctuate based on the company's business success. The mutual fund's share price is determined by its net asset value, which also fluctuates with the circumstances of the companies within the fund.

Risk Levels

The first important decision you have to make is what kind of risk you are willing to take. You can take the conservative route, which will mean lower returns but a lower chance of losses. Or, you can take a moderate route, which includes a mix of risky and conservative options and moderate-to-low returns. Or, you can be aggressive and go for options with high earning potential but also higher risks. As a fund's potential return increases, its level of risk increases. Risk is essentially the fluctuations that will be a part of any fund's existence. This means that the time frame in which you have to invest will greatly affect the plan of attack you decide on for your 401(k) investments.

For example, if you are going to need the money sooner than later, then your risk tolerance will be lower and you'll need to choose low-risk investments with a more consistent and stable history of returns. You can also lower your risk by diversifying your investments.

If you have many years of investing ahead of you (10 or more), then you can probably afford to take more risks. The longer you have your money invested, the longer you will have to recover from any losses.

Your own personal feelings toward investing are also a big factor. Stressing over investments is not good for anyone. Think about what risk you are comfortable with and then plan your investments accordingly. Remember that most plans let you rearrange or "rebalance" your funds at least quarterly, and in some cases you can rebalance as often as you want.


Making Your Selections

Of the choices you have, the riskiest, but also the option with the most earning potential, are stock mutual funds. Historically, stocks as a whole have had average annual returns of close to 11 percent. The tricky part is to select the right stock mutual funds. How do you know which are the best performing funds? According to an article by the Motley Fool, "Over time, the absolute best performing type of stock mutual funds, bar none" is an index fund. An index fund essentially matches the market. It has no manager and is simply made up of representative amounts of each stock in the index. It is the safest bet on achieving a steady rate of return that can come very close to or match that 11-percent average.

There are several index funds. The most well-known is probably the S&P 500 index. This index fund performs well, but there are also others that perform well -- such as the Wilshire 5000. Because it is very difficult to pick stocks individually that outperform an index like the S&P 500, it makes a lot of sense to invest in an index fund. The same article by the Motley Fool states that index funds outperform between 80 percent and 90 percent of actively managed equity funds.


The problem comes in when your 401(k) plan does not offer an index fund. What do you do then? Part of the boost in an index fund's value comes from the fact that is not actively managed, and therefore doesn't have the fee associated with that management. You can put together some funds that might act like an index fund, but it will take some work. The first things you have to look at are the fees and commissions that are charged. Look for a fund that has management fees less than 0.75 percent, no sales charges, and no 12b-1 fees. (12b-1 fees are annual fees that the fund uses for its marketing efforts.) You also want to look for a fund that has low turnover of stocks -- that typically means that it performs well. The fund's past performance is also a good indicator of future success, but is not a guarantee.

Doing Your Homework

Don't blindly choose stocks without knowing anything about them. Do a little homework. Your plan administrator should have information available for you about each fund. These are often available online as well. Read the prospectus of each fund and select the ones that you find fit best with your own philosophies and ideas.

To build a diversified portfolio of funds, one strategy is to select 25 percent of funds from small-cap stocks, 25 percent from mid-cap stocks, 25 percent from large-cap stocks, and 25 percent from international stocks. If your 401(k) plan doesn't offer all of those options, then you can fill in the missing ones with an IRA. The idea is to spread out your investments to create a diverse portfolio. This helps balance out your risk because when you have one fund that is up, you'll probably have another fund that is down. The large-cap funds are less risky, but the small-cap funds often have more growth potential.


In order to keep this balance, you also need to remember to check back from time to time and make sure you still have the same percentages for each type of fund. If companies within a fund are doing extremely well, they can often be pushed to another level, in which case your investments become off-balance.

What to Watch Out For

Here are some things to watch out for:

  • Having a high percentage of your company's stock - Since the Enron debacle, many companies (and employees) are taking a look at their 401(k) offerings and evaluating the mix of outside stocks with company stock. It is not recommended to have more than 20 percent of your portfolio with one stock. Some companies encourage employees to buy their stock and may even give the 401(k) matching amount in company stock rather than cash. This creates a very unbalanced portfolio for employees.
  • Missing out on some of the employer match because you don't contribute enough - For example, say your company matches 50 cents on the dollar up to five percent of your salary. That means that if you only contribute three percent of your salary, you're missing out on some of that free money. Let's look at the numbers. If you earn $40,000 per year, that means contributing $1,200 (three percent) would mean your employer is only contributing (matching) $600 rather than the $1,000 they would be putting into your account if you were contributing the full five percent ($2,000). In this scenario, you are losing $400 per year in free money. That may not seem like such as terrible thing, until you look at what that single year's lost $400 would do in 20 years at an average stock earning of 10 percent -- that $400 would grow to $2,955.62.


Employers Benefit and Responsibility












Regulatory Compliance Issues







