In Part 1 of this series, we briefly discussed how retirement planning had changed from the days when Joe went to work for The Big Company. Back then, the company provided a pension plan that paid Joe a retirement income based on how many years he’d worked for the company and how much he made while he worked there. Today, his grandson, Joe3 works for a company that offers a 401(k) plan rather than a pension. But, how does the 401(k) work?
A 401(k) plan has much in common with an IRA. Like an IRA, the 401(k) allows Joe3 to reduce his taxable income by contributing money into the plan. Joe3 directs his employer to deduct a specific amount of money from each paycheck. These untaxed funds are invested in accordance with instructions that Joe3 provided when he authorized the deductions. The growth of the investments is not taxed until such time as Joe3 takes money out of the account.
Because this is intended to serve as his retirement plan, Joe3 is expected to leave the money in the account until he is at least 591/2 years old. If he withdraws money from the account before that age, he will pay ordinary income taxes on the money withdrawn; and, he will pay a 10% penalty for the premature withdrawal.
One of the real advantages of the 401(k) plan is the ability to contribute far more to the plan than is permitted for an IRA. While the maximum contribution to the IRA in 2012 is $5,000, an individual can contribute up to $17,000 into the 401(k).
Another advantage is that this plan allows an individual to reduce his or her taxable income regardless of annual income.
Moreover, because the 401(k) plan entails regular, consistent, investments, the individual is able to take advantage of the concept of “Dollar Cost Averaging”. Dollar Cost Averaging simply means that the purchaser buys more shares when prices are low and fewer shares when prices are high. Consider this example. Joe3 has decided to invest $100 each month in stock issued by the XYZ Company.
| Month | Price Per Share | Total Shares Purchased |
| January | $10.00 | 10 |
| February | $5.00 | 20 |
| March | $20.00 | 5 |
| Total | $300.00 | 35 |
As can be seen, Joe3 has invested a total of $300. If he decided that he wanted to sell all of his shared in the XYZ Company, how much would he have to sell them for in order to make money; $5, $10, $20, or something else? If we divide his $300 investment by the 35 shares he owns, we can see that he paid an average of $8.57 per share; thus, he’ll make money if he sells the entire investment for more than $8.57 per share. Of course, this does not include any fees that he may have to pay when selling the shares.
Now, let’s extend this concept into Joe3’s 401(k) program. If Joe earns $500 per week and directs his employer to deduct 10% ($50) from each check and place that money into his 401(k). When prices are high for Joe3’s chosen investment, he will buy fewer shares at the high price. When prices are low for Joe3’s investment of choice, he’ll get more shares. At his retirement, Joe3 will have amassed a significant retirement account that he can convert into a regular monthly income to support him in his golden years.
One final potential advantage should be recognized here. Some companies provide some type of matching contribution to an employee’s 401(k) contribution. Joe3’s company contributes $0.50 (fifty cents) for every dollar that Joe3 puts into his 401(k). This represents an immediate 50% return on his investment so longs as Joe3 remains with the company long enough to “vest” that matching contribution.
Companies have a choice in vesting schedules; specifically, that matching contribution becomes the employee’s money when one of two schedules has been met.
- “Cliff Vesting” – the entire matching contribution becomes the employee’s property after 2 years of employment.
- “Stair-Step Vesting” – the matching contribution becomes the employee’s money in increments; i.e.,
- 20% of the matching contribution belongs to the employee after 2 years of employment;
- 40% of the matching contribution belongs to the employee after 3 years of employment;
- 60% of the matching contribution belongs to the employee after 4 years of employment;
- 80% of the matching contribution belongs to the employee after 5 years of employment; and,
- 100% after 6 years of employment.
Some employers measure the beginning of the vesting period from the initial date of employment while others measure it from the date on which the matching contribution was made by the company. Of course, the employee’s contributions to the plan always belong to the employee and cannot be taken away (which is not to say that the value is always the same … the value can increase or decrease based on the performance of the investment that the employee has chosen).
Just like the IRA, Joe3 must begin withdrawing money from his 401(k) by the time he turns 701/2. Failure to make the minimum annual withdrawals will result in the assessment of tax penalties.
401(k) plans offer employees a great way to plan for retirement through the use of payroll deductions (if you don’t see the money, you don’t miss the money) and growth within a tax sheltered environment. If your employer offers this type of retirement plan, check it out … someday you’ll be very glad you took advantage of the opportunity to plan for your future retired life.
NEXT UP … 403(b)