401k Plans Explained

by Gary Foreman

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Hi Gary,
My uncle is very upset because he doesn't understand how his 401k works. He thinks they are trying to tell him what he can do with his retirement money and so forth. I don't know how to explain the basic point behind a 401k or how it works. Can you help me?

Like most good things, the 401k retirement plan has some strings attached. And the truth is that Amber's uncle is right. The company can, in fact, control the choices for investing the money within the 401k plan. In this case, it's a price that's usually worth paying.

The 401k plan has gained steadily in popularity. An estimated $3.5 trillion dollars are invested the plans. Studies show that 81% of employees of businesses who offer retirement plans are offered a 401k plan.

So it's not surprising that Amber's uncle has a plan available to him. Many financial advisors encourage clients to use 401ks and IRAs to supplement company-sponsored pension plans and Social Security.

The 401k works pretty simply. The employer will select a plan administrator. A number of investment options will be made available within the plan. Typically the options will include a guaranteed vehicle (certificates of deposit), a few mutual funds, and the employer's own stock (if it's publicly traded).

The employee will be allowed to contribute a portion of their wages to the plan. There will be a maximum percentage. One of the big advantages to the plan is that the amount you contribute reduces your taxable income. So if you earned $50,000 last year and contributed $1,000, your taxable income is $49,000.

You won't pay taxes on the 401k money until you withdraw it. Then you'll add any withdrawals to your ordinary income. And if you take money before age 59 1/2, you'll also face a 10% penalty, except for certain loan options and approved hardship withdrawals.

But, by delaying taxes on your contribution, it's like giving yourself a pay raise. For someone making $50,000 per year, a 2% contribution could save them $280 in taxes.

The tax benefit also has a hidden effect. Because taxes aren't deducted before you make your investment, you have a full $1 that begins to earn money right away. That's a big difference. For instance if you had paid 28% in taxes, only 72 cents would have been invested. And that 72 cents would need to earn nearly a 40% return before it would become $1 once again. Even in good markets that takes a couple of years.

And that's only the beginning of the good investment news. Some companies offer to match a portion of your contribution. For every $1 you contribute they'll add 25 or even 50 cents. What that means is that you've gotten a 25% or 50% return on your money before the investment does anything. So even if the investment choices offered underperform your favorite by 10% or so, it really doesn't matter.

Combined, those two benefits can create a very nice return on your investment. For illustration, let's assume that Amber's uncle earns $50,000 annually as described above. He contributes 2% of his salary and the employer matches 25 cents to the dollar.

What does Uncle get for his dollar contribution? Well, to begin with, there's no taxes deducted from it. And, the company will add a quarter. So his dollar is worth $1.25 before his investment does anything.

How would it compare if he invested it on his own? The dollar would be taxed and he'd only have 72 cents to actually invest. His investment would need to earn nearly 75% before it would equal the $1.25 that he has in the 401k plan. Quite a difference.

For this privilege Amber's uncle will need to be willing to stay within the investment selections available to him. But, even if they underperform his real preference it will take a number of years before they make up the 75% head start that the 401k investment has.

Within the choices available there are a couple of things that Amber's uncle can do to make the most of his investment. Because the funds are meant for retirement, you'll be taking a longer view with the investments. That means you can afford to take more risk than you could if you expected to need the money in a year or two.

The second suggestion comes as a caution. Don't voluntarily buy company stock. If the company hits on hard times, not only will your investment be hurt, but you could also lose your job at the same time.

Finally, remember that it's money that you don't see. You don't need to work at saving. It's safely put away before you'd have a chance to spend it.

calculator iconCalculator: How much income will my retirement savings provide?

Overall, a 401k plan is an excellent way to save. Amber's uncle could find that the money he invests today will provide a significant portion of his post-retirement income. And, yes, he's right. They are controlling his investment options. But, in most cases, that's a cheap price to pay for the benefits of a 401k plan.

Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter or visit Gary Foreman on Google+. Gary is also available for audio, video or print interviews. For more info see his media page.

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