If you have a traditional 401(k) plan at work, you can contribute part of your salary, before taxes, to an investment account for your retirement. By making these contributions you are in effect reducing your taxable salary and lowering your overall federal income tax burden now, while setting aside money for your retirement. Your employer may also match part or all of your contributions, and may make contributions to the plan regardless of whether you contribute to the plan or not.
As a result of some changes in federal laws on pension plans, it is possible that you have already seen, or will see some changes in the way your 401(k) plan is handled. These changes could add certain new options and eliminate others. As a result, it is possible that you will have to make some decisions regarding the 401(k) plan your already have, or regarding a new plan your employer may be offering.
The Roth 401(k) is an option that was first allowed in January 2006 and now with the change in pension plan legislation it has been made permanent. A Roth 401(k) is different from a traditional 401(k) plan in that contributions to the plan are made after taxes. Therefore, when you make contributions to a Roth 401(k) you are not reducing your federal income tax. But when you retire, all withdrawals are tax-free, while distributions from a traditional 401(k) are taxable. With a Roth 401(k) you can make withdrawals after five years.
This option can be advantageous for young workers who expect their effective tax rate to increase over time, and for workers who have a high level of income and therefore a high tax rate which will probably continue over time. On the contrary, for workers who expect that their tax rate will decrease when they retire, the traditional 401(k), which allows them to reduce their taxable income now, may be more beneficial.
An advantage of the Roth 401(k) is that when you leave your job you can transfer the money you have in your Roth 401(k) plan to a Roth IRA, which is not subject to the same requirements as a traditional IRA in terms of the minimum distributions you must receive when you reach age 70 and half. Therefore, you can prolong the tax-free accumulation of gains in your Roth IRA for yourself and your beneficiaries.
The change in the legislation allows companies to automatically enroll their employees in the 401(k) plan, giving them the option of not participating if they choose not to. This is a personal decision that each person will have to make, depending on his or her own economic circumstances. It is important to save for retirement, and if you can adjust your budget in order to offset the reduction in the net take-home pay you will receive after contributing to the 401(k) plan, it is worth doing.
Distribution of Investments
Your employer may change the investment choice that is made by default when you do not specify which investment option you want for your 401(k) plan. While before, this investment option by default could have been a money market fund, now there could be different options. These include balanced funds with a more or less fixed percentage distributed between investments in stocks and bonds; a life cycle fund in which the distribution of investments changes from stocks to bonds as you approach retirement age; or managed accounts, which are combinations of investments managed by computer according to market indices.
Balanced funds are designed to maintain a certain distribution between different types of investments according to the level of risk, for example 60% in stocks and 40% in bonds. In some funds a percentage could also be allocated to money market funds, which would be the safest, but normally have the lowest return.
A redistribution of investments is made in the fund in order to adjust for changes in the market values of the investments. For example, when the value of stocks rises, part of the increase is taken to invest in bonds, to maintain the original percentage distribution. Since these funds balance themselves automatically, you are relieved from having to actively manage investments in order to maintain the distribution of investments you want.
Life Cycle Funds
Life cycle funds are designed to assign a greater portion of your share in the fund to more conservative investments, like bonds, as you get older. These funds treat everyone of the same age equally, so you will have to take into account your own personal plans. For example, if you are 55 years old but plan to continue working for many years, you may prefer a life cycle fund designed for a younger person that offers you the chance to have a larger percentage of your share of the fund in investments that provide a greater return, even though that means a greater risk.
These accounts incorporate the feature of a distribution of investments according to your age, but are more adapted to your personal situation. They diversify investments to include stocks outside the company where you work, and they take into account how much you have saved, your other investments outside the plan, and even your spouse’s investments. Some managed accounts diversify based on changing conditions in the markets. You need to be aware that these accounts can mean significant charges. If your employer is not assuming all the charges for the plan’s administration, you may have to consider the cost as a factor in your decision.
Smaller Selection of Funds
Some employers are reducing the number of funds among which their employees can choose to invest the money they have in their 401(k) plans. The reason is to reduce costs and is also the result of studies that indicate that a larger selection of funds does not always mean a better allocation of the employees’ and the company’s assets. If you are a passive investor and the selection includes one or more mutual funds that suit your investment objectives, the smaller selection will probably not affect you. On the contrary, if you are an active investor and want the option to purchase any stock or bond you choose, you may possibly be able to negotiate a “window” that allows you to do so. This would generally come with higher charges for managing the account.
Be Aware of the Charges
When your employer takes responsibility for all the charges associated with managing the 401(k) plan, you have nothing to worry about. But when some of the charges are transferred to the employees, you should be aware of them. In order to evaluate your plan, you should look at the administrative charges and annual maintenance fees, and should find out whether there are charges for making purchases and sales of investments in the plan.
If your plan offers mutual funds as one of the investment options, you can examine the expense ratio that appears in the fund prospectus. You can compare the expense ratio with the ratio for comparable mutual funds that are sold publicly. In the prospectus you can also look at the turnover rate, which is the frequency with which the fund manager buys and sells investments. A high turnover rate normally means a higher charge for commissions and expenses.
The decisions you make regarding your 401(k) plan should take into account your age and your plans with respect to when you want to retire; your other savings, investments, and assets; whether you want to actively manage investments or prefer passive management; your capacity to accept risk in exchange for a potentially higher return or your need for more security in your investments; and your tax situation, that is, whether a Roth 401(k) plan, if offered, could be a good option for you.
When your employer offers matching contributions, it is important to take advantage of this benefit and make the necessary contributions to take full advantage of the match, because in effect this means money for your retirement that you will lose if you don’t make the corresponding contributions.