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The 401(k) plan is a type of defined contribution pension plan available in the United States. Named after a section of the 1978 Internal Revenue Code, it is a device to provide tax advantages on money set aside for retirement. Other types of defined contribution plans include 403(b) plans covering workers in non-profit entities and the 457 plan that covers employees of state and local governments.
401(k) plans must be sponsored by an employer, typically a corporation. The employer acts as a plan fiduciary and is responsible for creating and designing the plan as well as selecting and monitoring plan investments.
The employee asks to have part of his salary paid directly, or deferred, into the 401(k) fund. In participant-directed plans the employee can then select from a number of investment options. In trustee-directed 401(k) plans the employer appoints trustees who decide how the plan's assets will be invested.
Taxes on contributions to 401(k) plans and the earnings on those contributions are deferred until the money is withdrawn from the plan. At the time money is withdrawn from the plan it is taxed as regular income. Withdrawals are typically made at or after retirement. In most cases in which employees take money taken from accounts prior to retirement they must pay a 10 percent penalty to the IRS.
During the decade of the 1990s the plan proved popular with workers because it has more flexibility than Individual Retirement Accounts, known as IRAs. 401(k) plans have higher yearly contribution limits than IRAs. Also, 401(k) plans are tax-qualified plans covered by the Employee Retirement Income Security Act of 1974 (ERISA) which means that assets held by the plans are protected from creditors. That protection does not apply to IRA accounts in some states.
Many plans also allow employees to take loans from their 401(k) to be repaid with after-tax funds at a low, pre-defined interest rates. The interest proceeds then become part of the 401(k) balance.
401(k) plans also proved popular with employers looking for ways to reduce their pension costs. In most cases, defined contribution plans are less expensive than defined benefit plans for employers. 401(k) plans also create a predictable cost for employers while the cost of defined benefit plans can vary unpredictably from year to year.
Many people will change careers, or at least companies, several times. Each time facing the question of what to do with the accumulated 401k benefits.
The choices are: keep your 401k with the old employer (sometimes possible), roll the proceeds into the new employer's 401k plan, or put them directly into a self-directed IRA at a chosen bank, mutual fund or brokerage firm.
Since leaving the 401k with the ex-employer has no benefits whatsoever and most employees will prefer to transfer out anyway, only two viable options remain:
1. Roll the 401k proceeds into the new employer's 401k plan (if allowed):
This is the easiest solution and the one that does not require much consideration. But there is more to think about.
The ultimate goal of having a 401k plan is to provide a comfortable retirement. To achieve this one needs a wide variety of investment choices and the opportunity to move among them in response to market variations.
Most 401ks are limited to maybe 15 mutual fund choices which rarely change, even if market behavior demands they should. Additionally, the canned advice provided through plan sponsors is generally not very useful.
The only benefit to this type of rollover is that if your plan has a loan provision, you are allowed to borrow funds easily.
2. Roll the 401k proceeds into a self directed IRA:
This is the preferred solution for most people, and it comes with two choices: roll the 401k into a “Contributory” or a “Rollover” IRA.
A. Contributory IRA:
Once the proceeds are rolled into this type of IRA, annually contributions are possible (check with your accountant). However, the 401k portion can no longer be rolled back into another 401k with a new employer, should the need arise. So the possibility of using the loan provision is eliminated with those funds. It is possible to borrow against an IRA, but it’s more limited than borrowing against an employer 401k.
B. Rollover IRA:
This type of IRA allows the most flexibility. Roll the proceeds back into a 401k plan to utilize a loan provision. But, for tax reasons annual contributions to this IRA should not be made. If making annual contributions becomes important, simply open another contributory IRA.
Since Rollover IRAs are usually set up at a brokerage firm, their entire universe of mutual funds is accessible. With this type of IRA, one can also employ an independent investment advisor to manage the account.
The investment results obtained with personal IRAs are far superior to those yielded by employer 401k plans or personal investing efforts. This is mainly due to a combination of better choices and a methodical approach to investing.
The bottom line is that Rollover IRAs offer opportunities to maximize benefits and provide better flexibility not generally available with employer 401k plans.
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