How to Manage a 401(k)

Guide Note:This page explains basic 401(k) language, benefits, downsides, and strategies to choose a plan right for you. Learn how to manage a 401(k)!

401(k): The Basics

Definition

  • It's an investment account. A 401(k) is an investment account in which the money, deducted from your annual salary, is intended to be used after retirement. A company typically arranges a 401(k) as a benefit of employment. The employee can choose from an array of investment options, which tend to be an assortment of Mutual Funds.

A Great Reason to Invest

  • A big benefit of participation is that contributions are often matched by your employer. In other words, if you choose to participate in your company's 401(k), your employer may also put money into your 401(k) account. Essentially, your employer will contribute money towards your retirement.
  • Note: This may not be the case with all company-sponsored 401(k)s. Please check with your employer.

Characteristics

  • 401(k) Contributions are pre-tax. When you contribute to your 401(k) account, money is deducted before taxes are applied to it (for further explanation, see the 401(k) Tax Implications section below).
  • You pay taxes at retirement. Taxes are paid on money withdrawn from your 401(k) account, not when money is deposited in your 401(k).
  • 401(k)s are restrictive. Withdrawals can be made after the age of 59½ with no penalties. Withdrawals made prior to age 59½ can be subject to penalties and Excise Taxes.
  • 401(k)s are insured. All 401(k)s are protected from creditors by the Employee Retirement Income Security Act.

Roth 401(k) Plan

  • The primary distinction between a traditional 401(k) and a Roth 401(k) has to do with the tax treatment. The Roth 401(k) allows you to contribute on a post-tax basis. In other words, money you deposit in your Roth 401(k) has already been taxed. Thus, when you retire and start withdrawing the money, you don't have to pay taxes on it. Taxes do apply to withdrawals and interest earned from traditional 401(k) accounts.

A Great Benefit of the Roth 401(k)

  • If taxes are going up, a Roth 401(k) would be a smart investment, because the money placed in your account has already been taxed. When you withdraw that money, you won't have to pay those higher taxes on it.
  • The table below shows the relationship between the Roth 401(k), traditional 401(k) and taxes. Notice when there is no change in taxes the investments grow at the same rate. However, as mentioned above, when taxes are rising the Roth 401(k) grows at a faster rate than the traditional 401(k). It's something to think about when you're choosing a 401(k) plan.
      • To get more details on the comparison of a Roth 401(k) and a traditional 401(k), check out the 401(k)HelpCenter
Roth 401k Comp
Figure 1:Roth 401(k) vs. Traditional 401(k)

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Why Invest in a 401(k)

Benefits

Goal: A comfortable retirement
Goal: A comfortable retirement
  1. It's free money. Typically, in a company-sponsored 401(k), the employer will contribute to each employee's 401(k) account up to a certain amount. For example, an employer may have a policy that matches 50% of an employee's contribution up to 10%.
    • What that means: To illustrate this type of policy, consider the following example:
      • Jack makes $50,000 a year and decides to contribute 12% of his pay (or $6,000) to his 401(k) account. On top of Jack's contributions of $6,000, his employer contributes $2,500 (or 50% of Jack's contribution up to 10% of his total pay). In total Jack will have $8,500 in his account at the end of the year.
    • Note: You may only be entitled to what your employer contributes to your 401(k) if you stay with your company for a certain period of time. For instance, your plan may require a minimum number of hours of service before you can keep the money your employer has put into your 401(k) account (for details you should ask your employer).
  2. It increases your take home pay.
    • To illustrate let's keep the same example from above.
      • Jack's taxable income (all else equal) will be $44,000 ($50,000 gross income - $6,000 401(k) contribution). If we assume a 25% federal income tax, Jack will pay $11,000 in taxes for the year. This leaves Jack with $33,000.
      • If Jack did not invest in a 401(k) account but rather put the $6,000 in a normal savings account, his taxable income would be $50,000 (all else equal). Now, assuming again a 25% federal income tax, Jack would pay $12,500 in taxes for the year. This would leave Jack with $31,500.
      • Extra take-home pay= $1,500
  3. It's cheaper. Since traditionally a company establishes a 401(k) for a large group of people, brokerage houses are able to provide better rates. It's cheaper than investing on your own (the idea here is similar to wholesale vs. retail pricing).
  4. It's painless. The money is automatically taken out of your pay check. You don't have to write checks or monitor deposits.
  5. You can retire early. At age 59½, you can start drawing on your 401(k) account, provided, of course, that you are retired. This is 5½ years before you can access social security.
  6. It's safe. Even if the company you work for goes bankrupt, creditors can't liquidate employee 401(k) accounts.

Downsides

  1. The money is tied up. Once you've invested in your 401(k) plan it's very hard to take that money out before retirement without sustaining heavy penalties and taxes.
  2. Limited choice. You are only able to invest in funds which are participating in the 401(k) plan your employer establishes.
  3. It can be restrictive. Rules concerning beneficiaries, withdrawals, and borrowing money are established by the employer.

401(k) Tax Implications

Goal: A nest egg
Goal: A nest egg
  • Tax Questions? visit www.irs.gov, or call 1-800-829-1040
  • Tax considerations when deciding to choose a 401(k) plan are important because it will have an immediate effect on your taxable income.
  1. Contributions to a 401(k) are on a pre-tax basis.
  2. Taxable income is reduced by the amount you contribute to your 401(k).
  3. Taxes are applied when funds are withdrawn.
  4. Taxes are also applied to the growth on the fund.
    • For Example:
      • Jane earns a salary of $45,000 a year, and decides to contribute $3,000 to her 401(k). Jane's taxable income for that year will be $42,000 (all else equal). Thus, the $3,000 amount will be put into your 401(k) and taxes charged to that amount will be applied when withdrawn.

Early Withdrawal Tax

  • If a withdrawal occurs before you are 59½, you may need to pay an excise tax equal to 10 percent of the amount withdrawn. This penalty is on top of the "ordinary income" tax that must also be paid on the withdrawal.
  • There are exceptions to the 10% excise tax, including but not limited to: employee death, the employee total and permanent disability, and a separation from service. For more exceptions and further explanation on this topic please see Publication 575, Pension and Annuity Income.

401(k) Contributions

  1. Maximum yearly contribution amount for 2007 is $15,500.
  2. Maximum contributions are adjusted for inflation, generally adjusting by $500 increments.
  3. If you are 50 or older, you may be eligible to contribute an additional $5,000 at any time during the year as a "catch-up" contribution. Most 401(k) programs have this feature, but check with your 401(k) administrator before proceeding.
  4. If your contributions are more than the maximum, the excess amount must be withdrawn by April 15th of the following year. This usually happens when an employee switches jobs in the middle of the year, and rolls over the old 401(k) plan from the previous employer to the new 401(k) plan. Penalties will apply if this violation is noticed after April 15th. However, in most cases your former employer will withhold a specific amount for taxes if you do decide to roll over your 401(k). Before proceeding with a roll-over please check with your 401(k) administrator.
    • For more information on 401(k) roll-over, check-out the following sites:
    • Note: If you change jobs, you have the option to keep your 401(k) vested with your former employer. It is not uncommon for there to be extra fees applied to your account if you do this due to the fact that you no longer work at the company that sponsored the 401(k). Another option can be converting your 401(k) to an Individual Retirement Account (IRA).
    • For more information on an IRA, check out the following sites:

Vesting

  • Definition: With respect to retirement benefits, vesting represents an employees' rights of ownership. In other words, if you leave a company before a certain amount of time working there, you will forfeit part or all of the money they contribute to your retirement fund (but not the money you have put in). Vesting can be either immediate of delayed; the vesting schedule is determined by your employer, and applies only to employer contributions, plus interest earned on that money. Your contributions, on the other hand, are immediately vested. In other words, when you invest in your 401(k), you have complete ownership over the money you have put into the account.
  • Immediate Vesting: Once you participate in your company's 401(k), all contributions (the money you contribute, the money your employer contributes, and the growth on the total sum) is completely yours.
  • Delayed Vesting: If your 401(k) account has a delayed vesting plan, it means that you don't have immediate ownership of (i) your employer's contribution to your account, and (ii) the interest your employer's contribution gained. Your ownership of these two elements of your 401(k) are only rewarded to you after a specified period of time. There are two types of delayed vesting:
    1. Cliff vesting is a feature in some 401(k) plans where you work X amount of years and after you complete the contracted number of years ('X' in this example) you attain full ownership of all money in your account.
    2. Graded vesting is a feature in some 401(k) plans where ownership of your employer's contribution, and the growth related to that contribution is given to you in increments.
      • For example, if Jack has a 401(k) plan that vests 20% a year each year Jack participates, then Jack will have 100% ownership of all funds in his 401(k) account after 5 years. However, if Jack decides to quit his job after his third year, he is entitled to 100% of what he put in to his 401(k) including the interest earned on that money, plus 60% of his employers' contributions including interest.

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How to Choose a 401(k)

Bloomberg Homepage
Figure 2:Bloomberg Homepage

Know What Type of Investor You Are

  1. Do you like to take risks?
  2. Are you more conservative?
  3. Do you have a long outlook?
  4. Are you planning to retire in the near future?
  • These questions are important in determining what your investment goals should be. It will also help in determining what type of investment you should make.
  • Most 401(k) plans are comprised of an assortment of mutual funds, and thus not as risky as investing in individual public companies. However, some 401(k) plans are more risky than others.
    • Note: Most 401(k) plans are a menu of mutual funds. The level of risk attributed to a 401(k) depends on the composition of that particular plan.
    • Things to remember when choosing a plan:
  1. Stocks are essentially certificates that represent ownership of a company. This type of investment tends to have more ups and downs. If the company does poorly, your certificate may not be worth the same amount as when you purchased it.
  2. Bonds are essentially loans. If you invest in a bond, then you act as the bank, in that you receive interest and principal payments. Bonds vary in risk from very secure (Treasury Notes) to very risky (Junk Bonds).
  • If you have a 401(k) that is more heavily weighted towards stocks rather than bonds, it is most likely considered relatively more risky.

Read the Prospectuses

  • A prospectus is an investment brochure given to you by your employer. It is intended for a prospective investor and will tell you information about the fund. This is a Securities Exchange Commission requirement for all brokerage firms. The prospectus will include investment objectives, policies, risks, services, and fees. It is important to read the prospectus when deciding which plan is right for you.
  • Things to look for in a Prospectus
  1. Up to date information on fee increases/reductions (provided in the supplement).
  2. Steps to establish an account. If you plan on opening an account, the prospectus will walk you through how to do so.
  3. Investment objectives. A detailed description is provided of how risky the fund is and how it plans to meet the investor's goal.
  4. Investment Highlights. This will detail any milestones the fund has hit, such as number of investors, periods where the fund out-performed the market, historical highs/lows, etc.
  5. Glossary of investment terms. A prospectus will often include a list of terms used in the brochure.

Do Some Independent Research

  • There is an abundance of finance sites on the web where you can research and compare your investment fund with the market.
  • Also, check out the Mahalo Greenhouse's Business Resources for a list of some great financial websites.

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Track the Performance of Your 401(k) Plan

  • Tracking the performance of your 401(k) is as important as tracking any other type of investment that you have. Appropriately comparing your investment to comparable plans or indexes is a good way to see if your plan is keeping up with the market.
  • Remember, you're not stuck with the plan you have chosen today. You do have the flexibility to change the plan you have (see your Prospectus, or ask your 401(k) administrator for more details).

Why Tracking Your 401(k) is Important

  1. Tracking your 401(k) plan will give you the ability to make educated investment decisions pertaining to your retirement.
  2. It will help you avoid major losses to your investment.
  3. It will give you a better perspective of the way the markets are moving.
  4. A lot of 401(k)s follow a specific stock index. In other words, the 401(k) plans tend to fluctuate with the Dow Jones Industrial Average, NASDAQ, or the S&P 500. By tracking the performance of the 401(k) you will be able to see if in fact it is out-performing the index it's emulating.

To Chart Your Fund with Yahoo! Finance

  • The Yahoo! Finance Chart is a great resource to track and compare your 401(k) with other funds and/or indexes.
  • Click on the graph below to see the comparison between two funds (FDVLX in blue, and USGNX in red) and The Dow Jones Industrial Average.
  1. Go to Yahoo! Finance Chart.
  2. Attain the stock symbol of your fund. On the chart below, the examples are the Fidelity Value Fund (FDVLX) and the USAA GNMA Fund (USGNX).
  3. Place the stock symbol in the "Add Compare Symbol(s)" to the left of the chart.
  4. Compare your fund to the indexes by clicking on the index of your choice in the top left corner of the chart. You can remove the graph by clicking in its respective box.
  5. If you want to compare your fund to another stock, bond, mutual fund, etc., place the ticker in the "Add Compare Symbol(s)" to the left of the chart.
  6. The chart below dates back one year; you have the option to choose a time frame by clicking on "1d" (1 day), "5d" (5 day), "1m" (1 month), etc. at the bottom of the chart
Yahoo!Finance Graph
Figure 3:Yahoo! Finance Chart

Resources for How to Manage a 401(k)


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Have any great tips on How to Manage a 401(k)? Post your thoughts to the discussion board or email them to Ryan M: ryan at mahalo dot com.