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Morningstar.com's Interactive Classroom

Course 202
401(k) Plans

Introduction

The retirement savings landscape is increasingly cluttered. It includes Social Security, different types of employer-sponsored plans, individual retirement accounts,and taxable accounts.

The next few classes are going to cover the retirement-savings terrain. We'll explore two of the most-popular types of employer-sponsored retirement plans, the 401(k) and the 403(b). Afterward, we'll compare traditional and Roth IRAs.

We'll begin with what is quite possibly the easiest money in retirement planning: the 401(k) plan. If your company offers a 401(k) plan, contribute to it. With a little effort, the payoff can be considerable.

401(k) Plans Versus Traditional Pensions

The pension is fast becoming a thing of the past. These days, more and more companies are adopting cryptically titled retirement packages called 401(k) plans.

A 401(k) plan (as well as its cousin, the 403(b) plan) is a defined contribution plan. This means that the amount you receive in retirement is based on the amount that you (and your employer, if there's a match available) contribute to the plan, in addition to the investment returns you earn on those contributions.

In contrast, "defined benefit" plans, such as pensions, generally pay a guaranteed sum based on your wages and years of service.

As investment programs, 401(k) plans have several great features:

They're automatic.
You can't forget to invest--your employer deducts your contribution from each paycheck. This forces you to invest regularly, even when the markets are down.

They invest pretax dollars.
Your investment doesn't take as big a bite from your paycheck as you might imagine, because you're investing pretax dollars in your 401(k) plan. As a result, a $100 contribution doesn't result in a $100 reduction in your take-home pay. In fact, you can save money on your income taxes now by investing in your 401(k): The income figure that the IRS uses is income after 401(k) contributions.

You don't pay taxes on investment gains until later.
Mutual funds make distributions, bond funds pay income, and equity funds often distribute capital gains. Unless you hold your mutual funds in a tax-deferred account (such as a 401(k) plan), you're responsible for paying taxes on these distributions, as well as on any gains you realize by selling an investment.

By investing in a 401(k) plan, however, you don't have to come up with more money for the tax man right now. You won't pay taxes until you begin withdrawing money from the plan.

Many employers match all or part of your contribution.
For every dollar you contribute to your plan, your employer might invest an additional 50 cents. Some plans are more generous and match "dollar for dollar" on at least a portion of the employee contribution. That's like getting an instant 100% return on your investment.

Say you earn $35,000 a year and contribute 10% of your income to your 401(k) plan. If your employer matches 100% on the first 4% of your contribution, your total contribution to the plan is $4,900. That's $3,500 from you and $1,400 from your employer. Over 10 years time, that $1,400 per year really adds up.

Given that this is really free money, try to contribute at least enough to your 401(k) plan to get the full employer match.

You control your own investments.
401(k) plans have shifted the risk of getting good investment results from employers to employees. You choose your own investments from a menu of options. 401(k) plan participants have greater freedom to control their financial futures than pension recipients do.

If you're an aggressive investor with a long time horizon, you can opt for the plan's racier options. Or, if you're near retirement age, you can be as conservative as the plan allows. It's up to you.

Understanding the Details of Your 401(k) Plan

Every 401(k) plan has an excruciating legal description, called the Plan Document. No need to pore over that. Focus instead on the Summary Plan Description (SPD). That document explains how your plan operates.

Look for the answers to these questions:

  1. How long do you have to work for your employer before you're eligible to participate in the 401(k) plan? Some companies let you start immediately, while others make you wait.
  2. How much of your salary can you contribute? The limit is set by law, but some plans have a lower ceiling based on a percentage of employees' salaries.
  3. How much of your contribution will the company match? Most employers complement what their employees stash away.
  4. What are your investment options? Most plans include mutual funds, and some have individual stocks--usually the employer's.

Finding the Right Mix

What do people do when they don't know which investment options to pick? They choose them all.

That's a bad idea. Your 401(k) plan isn't like a smorgasbord where you can try a little of everything. It's important that you understand your investment choices and that you choose the ones that will allow you to reach your investment goal.

Many 401(k) plan sponsors offer retirement-planning tools. This can make finding the right mix of funds for your retirement plan easy.

All you typically have to do is answer some questions about your age, how much you're currently contributing to your retirement plan, your income goals in retirement, whether you'd be willing to work part time when retired, and a few questions that will help the program gauge how much risk you're comfortable with.

Retirement-planning tools cananalyze that information and the funds your retirement plan offers, weighing their strategies, risks and returns, and expenses. They often give you the odds that you will meet your goal and recommend a mix of funds to get you there (put 45% in Fund Z, 23% in Fund Y, and so on). If the chances of you achieving your goal are poor, you will have the option of revising some of your parameters to improve your odds.

Quiz 202
There is only one correct answer to each question.

1 The 401(k) plan is a type of:
a. defined contribution plan
b. defined benefit plan
c. pension
2 How do you invest in a 401(k) plan?
a. You write a check to your 401(k) plan provider each month
b. Your employer automatically deducts your contribution from your pay
c. You don't invest any of your salary in a 401(k) plan--your employer throws in all the money
3 What are the tax advantages of a 401(k) plan?
a. You won't pay taxes on any investment gains until you begin withdrawing from your plan
b. You invest with pre-tax dollars, which saves you money on your current income taxes
c. Both A and B
4 What's the minimum amount you should try to invest in your 401(k) plan?
a. $2,000
b. The legal limit
c. At least enough to get the employer match
5 How should you choose from among your plan options?
a. Choose options that will allow you to reach your financial goal
b. Put some money in each of your options
c. Invest only in stock funds
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