Why it Matters
- It could be free money from your employer.
- It will give you a lower taxable income
- Savings and earnings that accumulate without you having to remember to make deposits.
- The opportunity to retire and not have to worry about money anymore
How It Works
- When you participate in a 401(k) plan, you tell your employer how much money you want to go into the account. You can usually put up to 15 percent of your salary into the account each month, but the employer has the right to limit that amount. It might be worth your while to rally for a higher limit if it isn’t as high as you would like it to be. The IRS limits your total annual contribution to $15,000 (for 2006).
- The money you contribute comes out of your check before taxes are calculated, and more importantly, before you ever have a chance to get your hands on it. That makes the 401(k) one of the most painless ways to save for retirement.
- If you’re lucky, your employer will match a portion of your contribution. Your employer wants you to participate in the plan because of compliance issues we’ll talk about later. The matched amount they offer (the free money part) is your incentive to participate.
- The money is given to a third party administrator who invests it in mutual funds, bonds, money market accounts, etc. They don’t determine the mix of investments — you do that. They usually have a list of investment vehicles you can choose from as well as some guidelines for the level of risk you are willing to take. Check out this other post I wrote on investment advice.
Advantages versus Other Ways to Save for Retirement
- Can contribute up to 15% of your salary up to $17,500 annually verses only $5,500 in an IRA. This allows you to have a lot more money invested with tax friendly growth.
- Employers often match it. Take advantage of this. It is FREE MONEY. Even if it is just $400, that $400 could realistically be $3000 in 25 years.
- There are lower fees in a 401k due to the group buying power it provides and having low fee investments funds is the key to high returns.
Frequenlty Asked Questions
When can I start to withdraw from my account?
At the age of 59 ½ you can start your withdrawal. This will be taxed because you did not pay any at the beginning, but you were able to put off taxes and enjoy tax free growth making this a great vehicle for your money to grow in.
What is the penalty for withdrawing early?
There is a 10% penalty plus the normal income tax on your 401k. You can somewhat get around this by taking a loan out against your 401k plan, but I would not recommend this.
Can I keep an old 401k from a previous employer?
There are no restrictions on how many 401k accounts you have. As long as the balance of your existing 401k is over $5,000, you can leave it at your current employer and start another 401k at your new employer. If the balance is less than $5,000, the plan sponsor has the option of requiring you to rollover the assets into an IRA or another 401k.
How can I rollover my previous 401k to my new one?
First, check with your new employer to ensure that their plan accepts rollovers. If they do, ask them for instructions on where assets from your old 401k should be sent and ask your former employer for the steps to get your old 401k to your new employer. The bonus is that there should not be any penalties for this.
Author Bio: I’m Lee Veldkamp, a financial blogger whose mission is to share people’s stories of financial freedom along my journey so that others may be helped along the way. Check it out at www.thevaluegeek.com.