Frequently Asked Questions

Q1: What is a 401(k) Plan?

Ans:

A 401(k) plan is a salary deferral retirement plan. Employees agree to put part of their salary into a special savings and investment account.  The money you invest isn’t counted as income when you complete your annual tax return. For example, if you earn $35,000 but put $5,000 into a 401(k) plan, your taxable income for the year would be only $30,000. Earnings accumulate tax free until retirement. A 10% early withdrawal penalty may apply to distributions taken prior to age 59 1/2.

A 401(k) plan can be a great way to save for retirement, especially if your employer offers matching contributions. If you are eligible to participate in a 401(k) plan, you should take advantage of the opportunity, even if you have to start by contributing a small percentage of your salary. This type of plan can form the basis for a sound retirement funding strategy.

Source:  http://www.finra.org/investors/401k-basics

 

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Q2: What is a Matching Contribution?

Ans:

Employers who make discretionary contributions to their employees’ 401(k) accounts commonly do so on a “matching” basis. Matching contributions are allocated only to those participants who defer into the plan. For example, for every $1 you contribute to your plan, the company might agree to add $0.25 or $0.50. Most companies will stop matching once you have contributed 3% to 6% of your own salary to the plan. As an example, if you earn $40,000 and your employer offers a $0.50 match for the first 6% of your salary you contribute to the plan. If you make a full 6% annual 401(k) contribution in the amount of $2,400.00, your employer will contribute and additional $1,200 as the employer match contribution. You may contribute a higher percentage of your salary (within the allowed limits), but in this example your employer’s match would only apply to the first 6% you elect to defer. To determine if your 401(k) plan offers a match, you may refer to your Summary Plan Description, or ask your Human Resources department if matching contributions are provided by your employer.

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Q3: Who Can Participate in a 401(k) Plan?

Ans:

Each 401(k) plan has a sponsor, usually your employer. The sponsor decides which factors determine your eligibility, what percentage of your salary you can contribute to your plan, whether to match your contributions and which investments will be available within your plan. The plan administrator keeps track of the company’s 401(k), handling management details and making sure that the plan runs smoothly. Your sponsor also chooses your plan provider, typically a financial services company that offers investment products, plan administration and record-keeping services.

Some provisions of your 401(k) plan are dictated by ERISA, the federal law that governs qualified retirement plans. For example, plans must cover all eligible employees and treat them equitably. Other details are specific to each individual plan. That’s why, if you move from one job to another, each with a 401(k), some things will seem familiar and others different.

401(k) plans are largely self-directed. You decide how much you would like to contribute to your plan, how you would like to invest—or reinvest—those contributions within the limits of your plan’s investment menu, and eventually how you would like to handle withdrawals from your account.

The federal government caps the amount you can contribute to your account each year.  You are also responsible for the investment results you achieve, though your employer has the obligation to offer appropriate investment alternatives.

With many employers, you have to sign up before you can contribute part of your earnings to your plan account. You have to choose how much to put away. And you decide where to invest your contributions, selecting among the investment choices offered in the plan.

Source:  http://www.finra.org/investors/401k-basics

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Q4: What is Vesting?

Ans:

The process by which a plan participant earns the right to keep his or her employer-funded accounts upon termination of employment. Note that the employee contributions are always 100% vested; vesting schedules only apply to employer derived funds. Each plan has a vesting schedule that defines the percentage of the account that the participant is entitled to should they terminate employment prior to being fully vested. The non-vested remainder is forfeited by the participant and reverts back to the plan (not the employer). This “forfeiture” is then “reallocated” to the remaining participants, used to finance future matching contributions for the employer or used to pay plan expenses. For example, if the vesting schedule on the employer match is “20% per year of service,” an employee who quits after three years of service will keep 100% of his or her own contributions (plus investment gains or losses) but only 60% of the employer matching account.

Source:  http://www.finra.org/investors/401k-basics

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Q5: How Can Contributions Be Made to a 401(k) Account?

Ans:

Generally, only your employer can make contributions to your 401(k) account. However, some plans will allow you to make after-tax contributions (defined later).

The following types of contributions can be made to 401(k) accounts.

1. Elective deferrals: These are contributions made under a salary reduction agreement. This agreement allows your employer to withhold money from your paycheck to be contributed directly into a 401(k) account for your benefit. Except for Roth contributions, you do not pay tax on these contributions until you withdraw them from the account. If your contributions are Roth contributions, you pay taxes on your contributions but any qualified distributions from your Roth account are tax free.

2. Non-elective contributions: These are employer contributions that are not made under a salary reduction agreement. Non-elective contributions include matching contributions, discretionary contributions, and mandatory contributions from your employer. You do not pay tax on these contributions until you withdraw them from the account.

Source: http://www.finra.org/investors/401k-basics

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Q6: Why Asset Allocation?

Ans:

More than timing or the specific securities you invest in, studies have shown that the way in which your assets are allocated in stocks, bonds, and cash and how they are rebalanced drive your returns.

Most investors focus on individual security selection and often overlook the importance of asset allocation to their portfolios. Yet, according to several academic studies, 90% of portfolio variance is determined by how your assets are allocated, so it is one of the most important decisions any investor can make. It also underscores the importance of relying on a disciplined investment process with asset allocation strategy at its core.

By implementing a systematic, global allocation of investment dollars, participants can help themselves reduce the risk within their overall portfolio while maximizing the returns they can expect to receive.

Asset Allocation

Asset allocation cannot ensure a profit or protect against a loss:

This is for illustration purposes only and not indicative of any investment. An investment cannot be made directly in an index. Past performance is no guarantee of future results. Source: Brinson, Singer and Beebower, Financial Analysts Journal, 1986. Brinson, Singer and Beebower, Financial Analysts Journal, 1991

How Much Will I Need?

Picturing yourself as a retiree may be hard if not impossible. But if you could envision those future years, you’d probably see a life full of activity and decades of health, happiness, and prosperity.

The reality, however, is probably somewhere in between. The problem with the picture is that the pleasure and comfort of your later years depend, to an ever-increasing degree, on the actions you take today.

Americans used to count on a pension plus Social Security to get them through those “golden years.” These days, people change jobs more often, rely on dual incomes, and manage their own retirement funds through defined contribution plans. By most estimates, you’ll need between 60% and 80% of your final working years’ income to maintain your lifestyle after retiring.

(Source: http://finance.yahoo.com/how-to-guide/retirement/18303)

Source of Retirement Income

This chart represents the income sources of American retirees.
Source: Social Security Administration, 2006.

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Q7: Five Questions to Ask Yourself About Your Retirement Plan.

Ans:

Do you know the answers to these questions?

No matter what your age, gender, or marital status, you need to know a few things about your and/or your spouse’s retirement plan. When setting your retirement goals, you shouldn’t leave anything to chance and getting the answers to these questions can eliminate future surprises.

1. Do you have a pension or retirement plan at your place of employment and are you eligible?

Some companies do not offer retirement or pension plans and some jobs within companies are not eligible for these plans even if they are offered.

2. How much will your pension or retirement plan be worth when you retire?

This information is necessary so you can decide if you need additional savings such as an IRA to supplement your retirement benefits when you decide to retire.

3. If your employer provides a retirement plan, what happens to it if you change jobs?

Your employer can tell you if your retirement plan can be rolled over into an IRA, cashed in, or left with the company if you should leave the company. You will need to decide which is best for you to do.

4. If you retire early, what happens to your retirement plan with your employer?

Your employer can tell you when you are vested with the company and what you can expect to receive in the way of retirement benefits when you decide to retire.

5. Will pension benefits be reduced by Social Security?

In some instances, your benefits could be reduced by the amount of Social Security you draw. Discuss this with your employer to see if this happens with your pension.

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Q8: Should You Borrow From Your 401(k)?

Ans:

These days, more than 85% of workers with 401(k)s can borrow from their plans.  If you’ve been diligently socking away a portion of your salary over the past few years (and you’ve had a match to boot), chances are that puts a lot of cash at your fingertips. It certainly doesn’t make sense to use this money for luxuries like a backyard swimming pool or a new car. But does it make sense to tap your 401(k)  to pay off a loan?

Typical plans allow you to borrow up to half your vested balance, but not more than $50,000. (Some plans might restrict borrowing to specific reasons, like a home purchase, education or medical expenses.) You usually must pay the money back, with interest, over five years. But, because you are paying the interest to yourself, it isn’t an additional cost. Just think of it as forced savings. If you don’t repay the loan, you will owe income tax and a 10% early withdrawal penalty.

Sounds like a pretty good deal, right? Well, there are a couple of big drawbacks. First, you are giving up the tax-free compounding of the money you withdraw. That could lead to a significantly smaller nest egg come retirement. Also, if you leave your current employer for any reason, you will probably have to pay the loan back immediately or face taxes plus a penalty.

Bottom line? Before you even consider tapping your plan, make sure you have no other non-retirement sources available to repay the loan.

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