Understanding 401K Plans - Case Study Example

Introduction Corporations are increasingly implementing 401(k) plans that are the latest version of the traditional retirement packages. The primary reason for the popularity of 401(k) plans, among corporations is that a 401(k) plan shifts the responsibility of providing retirement and pension benefits to the employees (cf: Arends). No longer, is the corporation required to define the retirement requisite or guarantee a retirement/ pension benefit to employees. Now, it’s up to the employees, to define their retirement goals and plan for it themselves. This can be a nerve-racking task for those who don’t have any experience of retirement planning or making investments. Nonetheless, 401k planning is not necessarily complicated if one strives to understand a few key concepts, even so it can be perplexing for the average person to take in the numerous unfathomable 401(k) documents. Understanding 401(K) Plans 401(k) plans are defined contribution plans, i.e. the plan defines the contributions that can be made, but not the profit to be acquired at the time of retirement. Therefore, the retirement sum cannot be known in advance. In a 401(k) plan employees contribute a portion of their salary that is automatically deducted from their pay check, before or after it is taxed. The employer can match the contribution made by the employees, even though they are not bound to do so by the law. The total contributions made by the employees and employers, are then invested into one or more funds provided in the plan. If the contribution is made on a pre-tax basis, then the investment returns are not taxed till the time of withdrawal, but if they are made after tax deductions, then only the return on investment will be taxed on withdrawal. Subsequently, the retirement amount depends on the contribution made by the employee and the employer (if the employer chooses to contribute), in addition to the returns on the investments made under the plan. Several corporations provide 401(k) plans that they find affordable and easy to manage. Employees can opt for such plans offered by their companies, but should be aware of the expense ratios of various investments in the plan, such as the fees and commissions brokers receive (cf: Spors). Advantages 401(k) plans have several advantages. An employee can contribute up to $16,500 from their salary and since the employer automatically deducts the contribution from each pay-check, there is no danger of forgetting or missing a contribution. This ensures that investments are made regularly; no matter what kind of markets conditions are prevalent. 401(k) plan also makes it possible to save on taxes, as the contribution is made from the pre-tax salary; taxable income is reduced, lowering the tax burden. The investments are also tax-deferred till the time of final withdrawal. It is also likely that the contribution made by the employee is matched by the employer (although there is no obligation to do so); this translates into additional income for the employee without having to do anything additional at work. Further, the employees have the option to choose their investments from a variety of investment vehicles, providing the participants more control over their investments (cf: Standard & Poor's). Additionally, the 401(k) plan offers employees over 50 the advantage of a ‘catch-up’ feature that allows them to contribute an additional sum of $5,500. Another advantage offered by many 401(k) plans is that it permits the employee to borrow up to 50% of the account balance, up to $50,000. This can later be systematically paid back with interest within five years, without incurring any penalties (cf: Standard & Poor's). To be fair to all levels of income groups the federal non-discrimination rules prevent highly paid employees from contributing a bigger percentage of their salary in the 401(k) than lower-paid employees contribute. According to "Building Your Nest Egg with Your 401(k)" (American Press Inc., Washington Depot, Conn.), this ensures that all employees profit uniformly from the 401(k) plan, and that it is not exploited as an investment vehicle for higher-paid employees. Disadvantages The most obvious disadvantage is that employers are not obligated to match contributions to the 401(k) plan. And though most corporations were matching part or all of the contributions, they desisted from doing so when the market took a plunge in 2008-09 and there was nothing that the employees could do about it, except bear the loss. Again, because of the market crash a majority of employees lost half their 401(k) funds in 2008. This has made employees wary of the 401(k) plans; the down-turn demonstrated the problems that can arise. Another, big drawback is that if employees make a withdrawal before the age of 59½, then they will have to pay 10% as penalty. Also taking cash distribution, at the time of changing jobs or retiring requires the employee to pay 20%; a 10% IRS penalty tax, and ordinary income tax on pre-tax contributions and earnings (cf: Standard & Poor's). In case of an employee, who has taken a loan from his 401(k) plan, and leaves the company before the loan is repaid in full, then such an employee may have to pay back the full loan immediately, depending on the plan's rules. Besides loans that are not repaid within the period stipulated, will be considered as withdrawals and be taxed and penalized accordingly (cf: Standard & Poor's). Conclusion It is the writer’s view that although the 401(k) plans have suffered due to the economic crisis, they still present a decent retirement plan option, if they are properly planned and implemented by all the participants involved, i.e. employees, employers and policy makers. While the policy makers are working on improving the plan, there is lot that employees and employers can do at their end. First and foremost, it is essential that the employees increase their savings to the maximum on a regular basis. Add to this, companies are once again planning to restore matching contributions in 2010 (cf: Walker), but even if a company does not match employees contributions, employees should further increase their contribution to make up for it. According to retirement experts, the employee and employer should contribute at least 10% to 15% of the worker's salary to build a healthy nest egg (cf: Laise). The end result is that a substantial amount will be invested, meaning that ultimately the employees will enjoy the benefits of the investments made. Next, it is very important that investments are sagaciously spread among stable as well as high return investment vehicles. As stated in “How to Make the Most of a 401(k)” the right mix should “include stocks for growth, bonds for income, or money market investments for protection of principal. This flexibility allows one to spread out contributions, or diversify, among different types of investments, which can help keep the retirement portfolio from being overly susceptible to different events that could affect the markets.” In case the market swings, 401(k) savers should persevere to investment decisions, instead of selling stock funds that have taken a dive. It must be remembered that markets eventually swing the other way, so in the long run most funds recover their value. Therefore, it is advisable to have a professional handle the investment portfolio, to prevent mistakes with regard to investments, especially in unstable market conditions (cf: Laise). Last but not the least; attention must be paid to the amount of fees the employee will have to pay toward fund management, commissions, etc. Then, a plan that incurs the minimum in terms of fees and commissions should be chosen accordingly (cf: Laise). If the above mentioned criteria are followed, 401(k) plans can prove to be very beneficial for employees, however, it is necessary that each individual employee take an active interest and keep track of its progress, so as to take appropriate action in case changes have to be made. Reference American Press Inc. Building Your Nest Egg with Your 401(k). Washington Depot, Conn. Arends, B. 2010. Do You Have Enough to Retire? Do the Math. The Wall Street Journal. http://online.wsj.com/article/SB126912089798665247.html?KEYWORDS=401%28k%29+plans Standard & Poor's Financial Communications. 2007. How to Make the Most of a 401(k). Business Week. http://www.businessweek.com/investor/content/sep2007/pi2007091_276522.htm Spors, K, K. 2009. Small 401(k) Plans Often Pay Big Fees. The Wall Street Journal. http://online.wsj.com/article/SB10001424052970204621904574251883387338254.html?KEYWORDS=401%28k%29+plans Walker, J. 2010. Some Job Benefits You May Never Get Back. The Wall Street Journal. http://online.wsj.com/article/SB127094487109975395.html?KEYWORDS=401%28k%29+plans Laise, E. 2009. Five Ways to Fix Up Your 401(k) Plans. The Wall Street Journal. http://www.businessweek.com/investor/content/sep2007/pi2007091_276522.htm Read More