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IRA / 401k Rollovers

How Does a 401(k) Plan Work?

Of all the retirement planning options that are available, 401(k) plans may be one of the best programs for accumulating retirement funds.

Unlike a taxable savings vehicle, a 401(k) plan allows you to make annual pre-tax contributions of up to $14,000 (in 2005). And pre-tax contributions are much better for savers than after-tax contributions. For example, if you are in the 25 percent federal marginal tax bracket, it effectively costs you only $75 of spendable income to save $100 for retirement. And it works out even better for those in higher tax brackets.

Like other qualified retirement plans, a 401(k) allows your money to grow tax deferred. This enables you to build capital significantly faster than similar investments outside the shelter of an employer-sponsored plan. Distributions from a 401(k) plan prior to age 591/2 may be subject to a 10 percent federal tax penalty and are included in gross income.

But thats not all. A 401(k) plan offers some additional benefits that make it particularly attractive.
 

Portability

A 401(k) plan is portable. Unlike some other employer-sponsored retirement plans, you can take your 401(k) plan with you when you change employers.
 

Within certain limits, the accumulated funds in your 401(k) plan can be rolled over into your new employers retirement plan without penalty. If your new employers retirement plan doesnt allow such transfers, you can roll over your funds into a traditional individual retirement account.
 

Employer Matching

Many employers offering 401(k) plans to their employees match contributions. For example, your employer may add an amount for each dollar you contribute, up to a certain percentage of your salary. Thats an automatic return on your investment.

Over the long term, matching contributions can help you to accumulate more retirement assets than plans based solely on employee contributions.
 

Investment Flexibility

A 401(k) plan can also provide a great deal of flexibility. Most 401(k) plans offer a number of investment options. This means youre able to choose how your retirement fund will be invested. Most plans offer a stock fund, a bond fund, a money market fund, a guaranteed investment account, and company stock. You can be as aggressive or conservative as you wish.

Of course, investments seeking higher rates of return also involve a greater degree of investment risk.

"Catch-Up" Contributions

Special "catch-up" contribution provisions enable those nearing retirement to save at an accelerated rate. Those aged 50 and older before the end of the tax year will be eligible to contribute more than the regular limits. Eligible 401(k) plan participants may contribute an additional $4,000 in 2005, with that amount increasing to $5,000 in 2006.

Final Analysis

If your employer offers a 401(k) plan, you should carefully weigh the benefits in light of your financial situation. A 401(k) plan can form the basis of a sound retirement planning strategy.

2005 Emerald Publications

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