More retirement plans today are structured as 401(k) plans. The term 401(k) is a reference to the IRS code that governs these plans. The basic features of a 401(k) are as follows:
- You allocate a certain amount out of each paycheck to be invested. This amount reduces your taxable income. If your paycheck is $2000 and you allocate $200 for your 401(k), then you will pay taxes on $1800.
- In many cases, your employer will match all or part of your payment into your 401(k).
- You pay income taxes on the money invested in your 401(k) when you withdraw the money.
- You can begin removing funds from your 401(k) at the age of 59 ½. You must start having some money withdrawn from your account when you are 70 ½ years of age.
- There is a maximum amount that you can contribute to your 401(k). This figure tends to increase each year. Should your employer contribute to your 401(k), this contribution does not count in the cap.
- Your employer will have a collection of investment funds you can select. Typically you allocate a percentage of your contribution to 4-5 funds. You can change your allocation a few times a year. You can also select investment options which will be adjusted by the fund manager based on market conditions.
- Should you change employers, you can keep your fund with your previous employer or roll it over to your new employer’s investment options.
- You can borrow from your 401(k). You can borrow up to half of the amount of your account with a cap of $50,000. You set up a repayment plan like any other loan. But in this case, the interest you pay is to yourself. There is an administration fee for the loan. This option is especially attractive for a down payment on a house.
For young graduates, investing in 401(k) can be complicated. Here are simple guidelines you might use.
- Take advantage of the full amount of your employer’s match.
- Most employers have pre-defined plans which give you the balance you need. These plans are geared to a risk-tolerance level you are comfortable with. Most view employees with select a plan that offers a level of risk that is prudent but yet not so conservative as to provide limited increase in the fund value.
- Stay continuously invested. When the market is down, your total fund value will decline but new contributions to the fund will essentially be buying more for your contribution. Conversely, when the market is up, your fund value will grow but your contributions will not buy as much. This concept is called dollar-cost averaging.
- Invest as much as you can early in your career. These early investments will ultimately become the greatest part of your future worth.
- Maintain a long term investment plan. You can find investment calculators on the internet that allow you to determine long term investment values.
One final note. If your employer is a governmental entity, a non-profit organization, an educational institution or like entity, you will have a 403(b) plan instead of a 401(k) plan. These operate much like a 401(k) plan..