Basic Rules for 401(k) Plans
For most people, 401(k) plans are likely to become your largest asset - by a wide margin. In fact, the value of these plans probably will become larger than all of your other assets combined. Furthermore, your 401(k) plan is likely to be your primary source of retirement income.
The recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 (The Act) provides for some important changes to 401(k) plans. These are discussed below.
Proposed changes to Social Security may result in smaller guaranteed payments when you retire. Social Security is not in great shape and providing benefits for the baby boomers will be extremely demanding on the resources. Be prepared to receive relatively lower Social Security benefits than prior generations.
This article provides very important basic rules for managing your 401(k).
Rule #1 Enroll in a 401(k) plan as soon as you become eligible. Do not procrastinate. Some employees do not enroll because they don't like the investment options. Although it is true that some plans offer better investment options than others, the benefits of matching employer contributions and deferring the tax on your contributions are so important that they greatly outweigh issues surrounding investment options.
Rule #2 Always contribute enough to your 401(k) to obtain maximum employer contribution. Frequently this means contributing 6 percent of your pay (with your employer matching with a 3% contribution). If possible, contribute the maximum amount allowed by law. The Act gradually increases the maximum amount that a participant can contribute to a 401(k) from $10,500 in 2001 to $11,000 in 2002 and then in $1,000 increments to $15,000 in 2006. Furthermore, The Act permits individuals age 50 or older to make "catch-up" contributions. The amount of this additional catch up contribution will start at $1,000 in 2002 and be increased $1,000 annually to a maximum of $5,000 in 2006.
On a related topic, The Act provides for increased IRA contributions: $3,000 in 2002-2004, $4,000 in 2005-2007 and $5,000 in 2008, plus catch-up contributions starting in 2002.
Rule #3 Diversify the investments in your 401(k) plan but avoid putting some money in each investment option. Lacking knowledge of investments, some employees believe it is safest to simply divide their contributions equally among all the investment options. This usually results in the inclusion of a money market fund that will slow the rate of portfolio growth.
Rule #4 Don't be too conservative, especially when you are young. Yes, during the past year the stock market has taken a beating. Nonetheless, history shows that it has significantly outperformed other investments such as bonds by a wide margin. We recommend a portfolio consisting primarily of stocks, including some international. Furthermore, if a broad-based index fund (such as the Standard & Poors 500 index) is available, consider making it the cornerstone of your 401(k) portfolio.
Rule #5 Never withdraw funds from your 401(k) plan before you retire. Often when employees change jobs, they withdraw funds from their plans rather than rolling them over into an individual retirement account or transferring them to their new employer's 401(k) plan. Withdrawals not only are subject to income tax but also are subject to premature withdrawal penalties. In addition, withdrawals will impact your retirement income significantly.
Younger people are especially tempted to withdraw funds when they change employers. They often rationalize that since retirement is years away and the amount in their plans is small, the withdrawal won't matter very much. This reasoning is absolutely wrong. In fact, the retirement benefits from all tax-deferred pensions plans (as well as individual retirement accounts) are impacted to a very great extent by the contributions made when employees are young.
Consider the following: Suppose you accumulated $10,000 at age 30 and were thinking of withdrawing it. Assuming a reasonable annual growth rate of 9 percent, the $10,000 would have grown to $204,130 at age 65. The $204,130 likely would translate into retirement income of about $17,000 per year. So, if you withdrew the $10,000 when you were 30, it would reduce your retirement income by about $17,000 per year. Never withdraw funds before retirement, if at all possible.
Contributions made when you are young have many years to grow. Consequently, they provide much more retirement income than equal-amount contributions made when you are older. So, start making 401(k) contributions as soon as you can, contribute as much as you can and never withdraw funds before retirement.
The information and planning ideas contained in this article are for general use only and may not be appropriate for all readers. Therefore, the ideas presented here should be relied upon only when coordinated with professional financial and tax advice.