Basics of 401-k retirement savings plan

The Social Security privatization debate has generated so many questions about retirement planning that we are having a hard time answering all of them right away. So we will start off with what Americans can do right away. So this article is about the basics of 401(K) program and how you should take full advantage of it.

What is 401(K)?

A 401(k) plan is a retirement savings plan that is funded by employee contributions and (often) matching contributions from the employer. At what point the employer starts to match and how large the match is varies by employer and is entirely the will of the employer. The key benefit of a 401 (k) plan is that the contributions are taken from pre-tax income (thus lowering your taxable income), and the funds grow tax-free until withdrawn after retirement. Also, the plans are (to some degree) self-directed in the sense that you control where the money is invested, though you will have only a limited choice of funds, and in some cases, a company might insist that you keep at least some of the investment in your employer's stock.

They are also portable; or in other words, they go with you when you change employers though you may not be able to carry with you all of your employer's contributions with you (you can always carry with you all of your contributions). Most employers insist that you work for certain number of years after the matching contributions are made. The term used is "vesting". It means that the money does not belong to you until you work for X number of years. For example, you may be required to work for 5 years to be 100% vested (or be able to take all the employer's contributions with you). If you work for only two years, for example, you may be only 20% vested (or be able to carry only 20% of the employer's contribution with you if you leave).

Who can join a 401(k) program?

If your employer offers a 401-K program, you can find out the eligibility requirements at your work. Typically, you need to be with the company for a certain number of months to start contributing.

You will required to complete simple paperwork and typically the plan administrator will help you do it and also help you picking the right investment.

How should I invest?

You should use a personal portfolio management approach for investing. Or in other words, depending on your age, risk appetite, and income, you should choose riskier investments (with potentially higher returns) if you are young, and relatively stable and secure investments as you approach retirement. At all points, you should be diversified to some extent so that you can take advantages of market booms and be protected somewhat from market collapse.

How actively should I manage my 401(k) account?

While it is a good idea to regularly watch the performance of your 401(K) investments, it is best to leave it alone most of the time. Only when there are major structural changes in the market (e.g. Internet stocks went totally out of favor in 1999/2000), should you reallocate your funds.

401(K) is not a short-term investment program and your time horizons should be counted in years/decades rather than months. Most data suggests that over the long term, stocks generally produce higher rates of return. Thus, it is good to pick funds that include companies that will be around for a long time and produce stable returns.

What else do I need to know about 401(K)?

It is best not to touch this money until you are retired. In emergencies and for certain types of personal situations, you may be able to withdraw funds or borrow against them. There are often tax implications of early withdrawals and you may have to pay interest on the loans. So talk to your plan administrator and make sure that you understand the risks of early withdrawal. When you change employers, you can simply rollover your 401(K) account to your next employer's 401(K) program or into an IRA.

What should I do next?

Do some more research on 401(K) programs and on retirement planning in general. Try to develop an understanding of the basics of investing and financial planning. Do some calculations to find out how much retirement income you will need and if you are saving the right amount each month to have the desired retirement income. Many websites have free calculators that allow you to make these calculations. In other words, get smart about investing because privatization of Social Security will force every American to become an investor.

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