What does your 401K look like?

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Us 20 something’s are truly beginning to understand the importance of retirement planning, even before we have made our way into the “real world.” We have generally accepted that our social security system will fail us, and that a gallon of gas will cast more than a new car by the time we are sixty! So, in order to enjoy a cushiony post-retirement life, we must start saving as soon as that first paycheck is handed out. One of the most popular ways of doing this is through a 401K program.

I believe that it will be very important to any student who makes his/her way into corporate America to understand the basics of a 401K. Until today, I had heard the term innumerable times, but never really understood the concept. I knew it was a retirement program through an employer, I had heard about matching contributions, and I knew that there are penalties for withdrawing money too early (like a CD), but that is pretty much it. However, after only a few hours of online research, I now understand the importance of this retirement program.

The 401K is a retirement program that was created by the IRS (under section 401 subsection K) to give people an incentive to start saving for their retirement. Each 401K program is set up by an employer (following government guidelines) and employees can contribute to their own personal accounts by having money withdrawn from their pre-tax income on each paycheck. This is an important point because it means that the money that is put into a 401K is tax-deferred. Be careful here, this money is not tax-free, but tax-deferred. This means that when you eventually withdraw the money from your 401K you will have to pay taxes on it, but by that time most people will be in a lower tax bracket.

Where does the money go? Well, a 401K is basically a personal investment portfolio, with the main difference being that capital gains and interest paid are tax-deferred until the money is withdrawn. You, the employee, will choose what your money is being invested in. Your money is handed over to and managed by a third party (known as a custodial account) financial institution and invested according to your wishes. However, your choices for investments are limited by your employer. Still, you will have a choice between stocks, bonds, mutual funds, etc. This brings me to my second important point: because a 401K is an investment portfolio, it can lose value. So, you can lose money in a 401K. Do your homework, invest wisely, and monitor your account.

There are a few more perks involved in a 401K. For one, even if your company goes under, that 401K money is still yours. Your employer cannot take money from your 401K, which makes it a little more secure than a pension plan. Also, if you decide to switch jobs, that money is still yours. You may sometimes be able to roll that money over into your new 401K with your new employer. If you do this, make sure that the check is made out to the new 401K account, and not you (or you will have to pay taxes and penalties for early withdrawal). Lastly, many employers will make matching contributions (up to a certain percentage of your income) each time you contribute to your 401K. So, it is a good idea to at least pay-in enough to receive the maximum amount of “free money” that your employer will give you.

Now before you go and blindly throw all your money in the first 401K you see, there are a few things to look out for. First, you should know that the IRS puts a ceiling on how much money you can contribute. That is, you cannot put in more than $15,500 (as of 2008) each year. Also, employee and employer contributions cannot be more than $46,000 each year or 100% of your income. Your employer also may place restrictions on how much money you can contribute, but remember that these number can and should be negotiated. Second, there is a penalty for withdrawing money too soon from your 401K. If you withdraw money before you are 59.5 years old (I know, random age) you must pay the taxes on that money PLUS pay a 10% penalty. Lastly, you must carefully read and understand your employers 401k program. Some employers may offer a company stock matching program instead of cash, which can create some undue risk by not having a diversified portfolio. Do not be afraid to ask questions or try to negotiate the fine points. This is your money and your future we are talking about!

Do not forget to do your homework. You should know exactly what happens when you withdraw too early or take a loan out of your 401K (yes that is possible). You should know exactly where your money is going, how it is being invested, and how often you can change the investments in your 401K (some employers may only let you play around with your investment choices every three months). Know how to roll over or transfer a 401K in case you decide to leave, or worse, get fired.

My last bit of advice is to not rely solely on your 401K. Remember, it can lose money just like any other investment. Your should diversify, diversify, diversify. Have a private investment portfolio, own property, and even consider an IRA. Do not let your hard earned money sit idle, or spend it on too much useless crap (some useless crap is ok, I mean, you should enjoy life too). Make your money work for you, so that you can eventually stop working for yourself.

Some helpful links: (also, my sources)

Fidelity: About 401K’s

HowStuffWorks.com (if you have never been to this site, it’s awesome. And really helpful.)

FinancialWeb “401(k) vs. IRA” (and alot of other helpful retirement planning articles)

Six Common 401(k) mistakes (one of those other helpful FinancialWeb articles.)