Monday, February 9, 2009

401(k) week, part 1

Just like I promised last week...

Here's a quick primer on what a 401(k) is and how they work:

  • A 401(k) is a retirement investment account sponsored by employers for their workers. (If you work for a government agency, it's probably called a 403(b). If you don't know if your company offers one, ask someone in HR today.

  • 401(k)s are named for the section of the tax code that gives them their most attractive features. First, the money you put in comes out of your paycheck pre-tax, which reduces your taxable income for the year. Second, that money grows tax-deferred, so you don't get hit with a tax bill at the end of the year like you would other investments. (Note I said tax-deferred, not tax-free. You'll eventually pay taxes on the money but not until you withdraw it, which shouldn't be until you retire, when you'll have a lower income and lower tax rate).
Many companies match a percentage of what you contribute. Say you make $50k a year and contribute 10 percent, or $5,000 a year to your 401. If your company matches 3 percent, that means they're giving you an extra $1,500 a year, without taxes, toward your retirement.

A couple of common misconceptions to clear up:
  • You own and control your 401(k), not your company. That means you decide which stocks, bonds or funds will be held in your account at all times, and that you keep all the money you put into the account and any gains you've made if you leave for another job.
  • There is something called "vesting", which basically means that you only keep the money that your company matches if you stay employed there long enough. The vesting period is usually between three and five years. If you leave before then It's their way of trying to guarantee they're getting a return (your work) on their investment (their money in your retirement account).
  • Whether you make or lose money in your 401(k) does NOT depend on how well your company's stock is doing. That is unless you've loaded up your account with company stock, which you should never do (think Enron). 401(k)s are made up of investments you choose based on how long you have before retirement and your risk tolerance (that's called "asset allocation" and I'll explain it tomorrow). But don't worry if you're working for a company that has a low stock price. If you have a good mix in your 401(k) account, it won't matter at all.

Back tomorrow with more. Any questions, post in the comments section


Butterrfly said...

Great post!!! Can't wait for tomorrow's lesson! :-$

Mary said...

This was very helpful