A 401(k) is an employer-sponsored plan that's funded by employee contributions that are deducted directly from the employee's paycheck. Many companies match contributions up to a certain percentage. Most employee contributions are pretax and grow tax-deferred until withdrawn, but after-tax contributions are also allowed.
One of the first considerations is how much money
to contribute. Generally speaking, you should contribute as much
as you can. You don't want to leave yourself cash-strapped, but
you also don't want to squander the opportunity to make pretax,
tax-deferred contributions and get a company match. Whether your
company match is dollar-for-dollar or something smaller, don't pass
up free money.
For 2004, the maximum pretax annual contribution an
employee may make is $13,000 ($15,000 if you're 50 or older.) Pretax
limits increase by $1,000 per year through 2006.
Employees are responsible for their 401(k) investment decisions.
Most plans have an array of mutual funds to choose from, but too
often there is little guidance as to proper asset allocation and
the role fees and expenses play in overall returns.
Before you can decide how to allocate your contributions,
you have to determine your risk tolerance. How much volatility within
the portfolio can you stand?
If you're in your 20s or early 30s you can afford
to be more aggressive with your investments because you have more
time to recover from slumps in the stock market. As you age your
asset allocation should shift to more conservative investments to
protect the earnings.
Many 401(k) plans offer tools (online
calculators, work sheets) for determining risk tolerance, but the
best tool may be a competent financial planner. It may be worth
hiring a planner to listen to your financial goals and evaluate
your assets and earning ability to help you craft an allocation
plan that will ensure a comfortable retirement.
Most 401(k) plans allow you to borrow up to 50 percent
of your vested balance, but not more than $50,000. In most cases,
you have to repay the money with interest within five years. The
interest payments go into your account, but there are downsides.
The money you withdraw for the loan is no longer invested
and, therefore, isn't appreciating. Also, the original contributions
to the account were made with pretax dollars, but the loan payments
will be made with after-tax dollars.
Unless your company has an outstanding 401(k) plan,
you should consider taking the account with you if you leave the
company. If you're going to another company, you may be able to
roll it over into the new company's plan. If not, you can roll your
401(k) into an IRA at a brokerage. This gives you more control over
your account and, in most cases, you'll have much better investment
options at a brokerage.
Just make sure you follow the proper procedures. The
plan sponsor or the human resources department will assist you in
transferring the money. You don't want to accidentally cash out
your retirement plan and get stuck paying taxes and penalties for
If you're an entrepreneur trying to maximize your
retirement savings, consider opening an individual 401(k).
A 401(k) plan used to be only for someone who worked
for a corporation, but no more. Owners of very small businesses
now can open 401(k)s and shelter thousands more dollars than they
could have in other kinds of self-employment retirement accounts.
The plans, often called individual or solo 401(k)s,
are available to businesses that have no other employees beyond
an owner and a spouse, although some partnerships can qualify. That
means sole proprietors, owners of mom-and-pop companies, even people
who work for someone else but have a side business, can open one.