401(k)

What is a 401(k) and Why Should I Have One?

Enron. Six months ago most Americans wouldn't have recognized the name. Now we're painfully familiar with how more than 4,000 Enron employees unexpectedly lost their jobs and retirement savings as the company collapsed. The downturn in the economy and the collapse of Enron has caused a majority of Americans to think about their retirement savings and, more specifically, the safety of their 401(k) funds. In fact, a recent Pew Research Center survey found that 58% of people surveyed think that stock-based retirement plans (like the one offered to Enron employees) are at risk.

More and more companies are offering 401(k) plans. A 2001 Employee Benefit Research Institute survey found that 55 percent of workers participated in these employer-sponsored retirement accounts. Companies use them as an alternative to the traditional pension plan where employees were guaranteed a certain amount of monthly or yearly income upon retirement. By creating 401(k)s, companies no longer have to manage or ensure retirees' pension plans. Now employees are responsible for voluntarily participating and actively participating in their 401(k) investments. 401(k) plans are called tax-deferred, defined-contribution plans. They are tax-deferred because contributions are taken out of your paycheck before taxes which lowers your taxes, and taxes on the income gained is deferred until you use the money in retirement. They are defined-contribution plans because both you and your employer decide, or define, upfront how much money you will contribute to the plan. In addition to 401(k) plans, there are 403(b) plans for public school workers, and people working for religious and nonprofit organizations, and 457 plans for government employees.

Here's how a 401(k), or tax-deferred, defined-contribution, plan works. You choose how much of your income you want to contribute to the plan. Often companies will match a portion of your contribution - meaning that, for example, they will put $.50 in your account for every $1 you contribute. Not all employers offer matching funds and the amount they will match varies. It's best to maximize your contribution, particularly if your employer will match your savings. Your contribution will be automatically deducted from your paycheck and directed to the investment plan of your choice. These choices may include mutual funds, individual stocks, annuities, or bonds. All companies are required to offer you at least three different investment options - places to invest your money. On average companies now offer 13 investment options to choose from. These plans will vary in risk -- the greater the reward (meaning the higher the return on your original investment), the higher the risk.

The most important factor to consider when determining how much risk you're willing to take is your investment horizon - how much time you have before you'll need your money. The longer you keep your money invested, the less chance you have of losing money. You should choose where you'll invest your 401(k) funds based on how many years you have before you retire…the closer you are to retirement, the less time you have before you'll need your money and the lower risk you'll want to take.

There are several advantages to investing in your company's 401(k) plan:

  • Your savings are automatically deducted from your paycheck, which makes saving for retirement more convenient for you…if you don't see it, you can't spend it!
  • The amount that you contribute from your income is taken out before your salary is taxed. By taking your 401(k) contribution out of your paycheck before taxes, it reduces your overall income. Why does that matter? Because less taxes means you take home more of your paycheck!
  • In many cases your employer will give you an incentive to save - they'll match a portion of your savings, which means they're investing money for your retirement.

For more information on 401(k) plans, check out the following links: