Smart 401(k) Investing—Retirement Savings Overview

The Basics

 

As you earn the income that pays for your current needs and at least some of the things that you enjoy, you may also be thinking about what you'll be able to afford when you retire—whether that's just around the corner or many years in the future. One of the ways to ensure you'll have at least some of the income you need is to participate in an employer sponsored retirement savings plan. So, instead of just dreaming about retirement, you're preparing for it.

 

A Brief History of Retirement

 

Since the Social Security Administration was created in 1935, the concept of putting aside some money now to be assured income in the future has revolutionized retirement for millions of people. Exactly how that assurance works is constantly being redefined.

 

Some employers offer defined benefit plans, which promise you a specific income, called a pension, after you retire, typically based on the number of years you work at the job and what you earn. Others offer cash balance plans, which calculate your pension based on a fixed return of an amount contributed each year in your name.

 

Still other employers offer defined contribution plans, such as profit-sharing or money purchase plans. These plans don’t promise a specific pension but provide retirement income based on:

  • the amount that’s contributed to the account;
  • the way the contribution is invested; and,
  • the return the investments provide.

 

Most employers who offer retirement plans provide one type or another. However, some employers have switched from defined benefit to a cash balance or defined contribution plan. Both types are portable, which means you can move your assets when you leave an employer.

 

Salary Deferral Plans

 

If the defined contribution plan your employer offers is a salary deferral plan, you can put part of your earnings into a retirement savings account. Your employer may contribute to your account as well. The best-known salary deferral plans are 401(k) plans.

 

Salary deferral plans are generally self-directed. This means you are responsible for deciding how to invest the money that accumulates in your account. Usually you must choose among a list of investments the plan offers. The advantage of self-direction is that you can select investments that you believe will help you achieve your long-term goals. But, of course, it also means added responsibility for choosing wisely.

 

When you participate in a traditional 401(k) plan, the taxable salary that your employer reports to the IRS is reduced by the amount that you defer to your account. This means income taxes on that money are postponed until you withdraw from your account, usually after you retire.

 

If you participate in a Roth 401(k), though, the amount you defer doesn't reduce your taxable income or your current income taxes. But when you withdraw after you retire, the amounts you take out are tax-free, provided you're at least 59½ and your account has been open at least five years.

 

Tax Benefits

 

Smart 401(k) Investing—Retirement Savings Overview: The Basics (Tax Benefits Graphic)Any earnings your tax-deferred contributions produce during the time they remain in your account are also tax deferred. This means the combined amount has the opportunity to compound at a faster rate, since everything is being reinvested and no money is being taken out to pay taxes.

 

And no matter how many times you sell investments that have increased in value, you won't owe capital gains tax on any profit you may make. Instead, you can reinvest the entire amount, although there may be transaction fees for your trades. Of course, if you sell investments that have lost value, you can’t claim your capital losses either.

 

The tax you eventually pay depends on your income tax rate at the time of the withdrawal. For example, if your combined taxable income including the withdrawal puts you in the 28 percent federal tax bracket, the tax you owe will be figured at that rate. Although there’s no way of predicting what your income tax rate will be when you withdraw from your account, many people have less income in retirement than they did when they were working, and so pay tax at a lower rate.

 

Vesting

 

 401(k) Fact
 A year of employment may be determined as 365 days from your first day on the job or as 1,000 working hours within a
12-month period.
 

Any money you contribute to a salary deferral plan and the earnings those contributions produce always belong to you—though you usually must change jobs or retire to withdraw or move the balance. In contrast, you don't have a right to the money your employer contributes to your account (or the earnings made from those contributions), or makes to any other retirement account for you, until you are fully vested, or have full legal rights to your account. Vesting is determined by time on the job.

 

Federal regulations set guidelines for vesting, but your employer determines which of the vesting schedules to use. You may be vested though one of three schedules: immediate, graded or cliff.

 

Immediate vesting means that you automatically have legal right to all the money added to your account.

 

Cliff vesting grants you the right to 100 percent of your account as soon as you work a certain number of years. That access must be granted within three years of your employment if your employer has made matching contributions to a 401(k) or similar plan. With plans that don’t involve matching contributions, such as defined benefit plans, the cliff vesting requirement is five years.

 

Graded vesting grants you the right to your account in increments over time. Vesting for matched contributions must occur over two to six years, with 20 percent access by the second year and 100 percent access by the sixth year. In defined benefit and similar plans that don't include matching funds, on the other hand, graded vesting must occur over three to seven years, with a required 20 percent access by the third year of employment.

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