A 401(k) plan acts as a defined contribution plan that is offer by a company and directed by the employee.
A Retirement Revolution
I don't ever remember hearing my late father talk about his retirement before he retired. He had a pension. A pension, for those of you who are too young to remember a time in America where these types of retirement plans were the lifeblood of those post-work years, is different than a 401(k) or an IRA in numerous ways.
It was a way for the company you worked for to say "thanks" for years of service. Workers received them when they retired. The size of the pension was based on the numbers of years you worked. The longer you were employed, a sure sign of loyalty, the more income the pension paid you when you retired.
When did that all change? Ted Benna, the story goes, found a line in the tax code that allowed employees to save for retirement with their own money, not the company's contribution. And better yet, they could do so before their taxes were levied. I think they call this kind of earth shaking reaction to a small event the butterfly effect.
The ButterFly Effect
Once businesses were free of the obligation to their employee's future, the pension disappeared. And the 401(k) was born. From the small Philadelphia accounting office came the single most profound change in the way we look at work and the time after it that has ever occurred.
Gone was the loyalty that pensions had once rewarded. 401(k)s were portable. You could leave one place of employment and take your money with you.
Gone was the retirement that the pension provided. Now, your retirement income was based on what you had saved in your 401(k).
Pensions required absolutely nothing from the worker in the way of investment savvy. 401(k) savers now needed the same skills as a Warren Buffet or Peter Lynch, both famed for their ability to turn some money into a lot of money using the stock market and in some cases, the bond market.
Gone was the obligation by the employer to fund a former employee's retirement. Pensions were fully funded by the company. The 401(k) proved to cost far less.
You at the Helm
This retirement tool was far more complicated than many people were prepared for, and judging from the number of people who use it incorrectly or do not participate at all, they still do.
A 401(k) offers you a basket of investments to use to direct your retirement dollars. These investments are usually mutual funds. Mutual funds, in the most truly, simplest of descriptions, are similar investors pooling their money together, hiring a professional money manager and hoping for the best. The money you contribute goes to that fund manager who in turn buys stocks or bonds or both. For a fee, they use their market knowledge to grow that money. The better they do; the more fruitful your retirement begins to appear.
The employer sweetens the deal by enticing you to save by "matching" your contribution. A match happens when a company offers to contribute the same amount of money to the plan as the employee does. It is expressed as a percentage, such as 'up to 3%'. The matching funds are often considered free money to the employee for their retirement plan.
All the employee had to do was pick a fund. Preferably three or four. You know, to be diverse and spread the risk.
That investment savvy the next generation of employee needed concerned itself with fees and returns, the markets and the economy, rebalancing and asset allocation and of course, diversity and risk. Is it any wonder half of the United States is not invested in anything?
The Benefits are Many
401(k) plans have many more upsides than downsides. Sure, learning the jargon is difficult but the benefits of learning how to employ this important retirement tool far outweigh the downside of learning a few market terms.
I mentioned portability. Your 401(k) is yours. You may take the money you have saved from your former place of work with you when leave. Although your new employer will not allow you to put it into their 401(k) you have to roll it over into another tax-deferred account such as an IRA, you did not forfeit your pension by simply changing jobs.
The benefit of tax-deferred savings is also a huge plus. The money you contribute can be taken out of your paycheck before you are taxed on the earnings. I often explain to kids just starting out that you can actually save more than the company¹s match and still take home the same paycheck as you would have had you not saved a dime. If Einstein was impressed with the simple elegance of compounding, he would have been knocked over by this.
401(k)s gave the average person access to better ways to grow their money. There is no doubt that investing in equities is far superior to any other kind of investing. There are those that suggest the best investments are real estate or being the owner of your own business. But using the stock market gave us manageable risk, a history of consistent growth, and best of all, a piece of the action.
Contributions
There is a limit on the amount of elective deferrals that you can contribute to your traditional or safe harbor 401(k) plan.
The limit is $16,500 for 2011 and $17,000 for 2012.
The limit is subject to cost-of-living increases after 2012.
Generally, all elective deferrals that you make to all plans in which you participate must be considered to determine if the dollar limits are exceeded.
Limits on the amount of elective deferrals that you can contribute to a SIMPLE 401(k) plan are different from those in a traditional or safe harbor 401(k).
The limit is $11,500 for 2011 and 2012.
The limit is subject to cost-of-living increases after 2012.
Although, general rules for 401(k) plans provide for the dollar limit described above, that does not mean that you are entitled to defer that amount. Other limitations may come into play that would limit your elective deferrals to a lesser amount. For example, your plan document may provide a lower limit or the plan may need to further limit your elective deferrals in order to meet nondiscrimination requirements.
Catch-up contributions. A plan may permit participants who are age 50 or over at the end of the calendar year to make additional elective deferral contributions. These additional contributions (commonly referred to as catch-up contributions) are not subject to the general limits that apply to 401(k) plans. An employer is not required to provide for catch-up contributions in any of its plans. However, if your plan does allow catch-up contributions, it must allow all eligible participants to make the same election with respect to catch-up contributions.
If you participate in a traditional or safe harbor 401(k) plan and you are age 50 or older:
The elective deferral limit increases by $5,500 for 2011 and 2012.
The limit is subject to cost-of-living increases after 2012.
If you participate in a SIMPLE 401(k) plan and you are age 50 or older:
The elective deferral limit increases by $2,500 for 2011 and 2012.
The limit is subject to cost-of-living increases after 2012.
The catch-up contribution you can make for a year cannot exceed the lesser of the following amounts:
The catch-up contribution limit, above, or
The excess of your compensation over the elective deferrals that are not catch-up contributions.
