401(k)

If your employer has a 401(k) plan, it is the easiest way to save money for retirement. It is a way to pay myself first because it is taken out of my paycheck before it is deposited into my checking out.

I think that saving for one's retirement is an important goal. Unless you are lucky enough to work for a company that has a defined benefit pension plan or are independently wealthy, you'll need to save. Hopefully, Social Security will still be around, but I have serious doubts about its solvency and I'll likely be getting very little in terms of benefits, if at all. Even then, I doubt that I could survive on Social Security alone if I'm not able to save anything, so saving something, if only a little bit is a must.

What is a 401(k)

A 401(k) plan is based on IRS code and are employer sponsored. There are two variations: (1) a traditional 401(k) account where money is taken out on a pre-tax basis and income taxes are deferred until withdrawal, and (2) a Roth 401(k) account where money is taken out on a post-tax basis, but withdrawals are tax free.

Benefits and Reasons to Invest

If you're lucky, you work for an employer that encourages 401(k) participation by matching a portion of the contributions that an employer makes. For instance, some employers will match 50% of your contributions up to 6% of your earnings, which is a 3% total contribution. This is free money! At the very least, in this scenario, one should contribute at least 6% of earning in order to maximize the employer match, but some employer contributions are subject to vesting requirements (some have a 4 year vesting period, were 25% of the employer match vests each year).

Another benefit if you invest in a tradition 401(k) is that it defers some of your federal tax liability for the current year. For instance, if you made $50,000 and contributed $5,000 to your traditional 401(k), then you'd only have to recognize $45,000 of income. This may also be a means to lower your tax bracket if you are on the fringe. However, note that withdrawals are taxed. In some sense, you only defer your tax liability but hopefully at that time, you will be in a lower tax bracket so the total tax liability will be less.

Downsides

There are a few downsides to investing in a 401(k):

• Some plans offer a limit set of investment choices. I would still do a bit of research because your contributions are still an investment and it may not make much sense if you have poor choices. Before investing in any fund, I do a basic search on Morningstar and look at each fund's ratings.

• Some have high fees. Look at BrightScope, to get an idea of whether your plan has higher fees than those of its peers. While it looks at outdated data, at least it will give you an idea.

• It's still a bit risky. Notwithstanding the tax benefits and the ease of "investing", it's still an investment subject to risk. Note that this is a long term investment and the stock markets (assuming you invest most of your contributions in stock funds) have generally gone up in the long term, there are still risks involved. Just look at the recent stock crashes. I remember looking at my 401(k) statements in dismay last year when the stock market plunged. It felt as though all of my hard work was all for naught and that I should have just spend the money (however, if I hadn't just kept on going, I would have then missed out on the impressive rebound, but let's see how that lasts).

Withdrawals

401(k)s are supposed to be long term investments. This is supposed to be for one's retirement. Thus, the most important question, really, is when can I withdraw the funds? When I started working, I was 27 and 65 seemed like an eternity away. Was I really going to put money away now so that I can enjoy it 38 years later? In some ways, I knew that I would have to save for my eventual "retirement" but it seemed so distant, so theoretical whereas I had pressing needs that needed immediate attention. Rent/Mortgage. Food. Entertainment.

But, I knew that I wanted to take advantage of the power of compounding and start investing early. I knew that the earlier I started, the better off I'd be so I bit the bullet and started contributing to my 401(k). I have faith that in the long run, the stock market will go up, but even if it didn't, I want to at least have some money put away.

So, when will I be able to start withdrawing money from my 401(k) accounts? At the earliest, when I'm 59 and a half (59 1/2). Any withdrawal before then would be subject to an additional excise tax of 10% on top of the ordinary income taxes, unless there is a exception such as a hardship withdrawal. Hardship withdrawals include payments to cover medical expenses, cover the down payment or to avoid foreclosure on your principal residence or to cover tuition.

To avoid this, you could consider a 401(k) loan, but there are also disadvantages to this approach as well.

Contribution Limits

I believe that the maximum contribution limit for the 2009 and 2010 year is $16,500. Future limits are indexed for inflation, but may increase in increments of $500. Employees who are 50 or over are allowed to contribute more (a "catch up contribution") of up to $5,500, which can also change in the future.

Generally, I think that 401(k)s are a great investment tool to enable a person to save for the future. It is automatic (taken out before I even get my hands on it) and I get free money in the form of my employer match.


Disclaimer: this is not investment advice. This just reflects my own observations and understanding of 401(k) plans.