Lowers how much tax you pay

A 401(k) lets you pay less income tax in two ways:

• Lower taxable income: You don’t have to pay federal income tax on the money you contribute with pre-tax contributions to your 401(k) plan until you withdraw it from the plan.

  If you’re making contributions to a Roth 401(k), you must pay tax now on the amount you put into the plan. (See Chapter 9 for details about Roth retirement accounts.)

• Tax deferral: You don’t pay tax on your 401(k) investment earnings each year. You pay tax on your pre-tax contributions, any employer contributions, and your investment gains on these contributions only when you make withdrawals.

  The investment gains on your Roth contributions are never taxed if you follow the rules.

The government provides these big tax breaks in an attempt to avoid having a country full of senior citizens who can’t make ends meet. (Nice to know the government’s looking out for seniors, huh?)

Tax deferral

In addition to the income tax savings on your contributions, you also save when it comes to paying tax on your investment earnings.

The gains in your 401(k) aren’t taxed annually, as they would be in a regular bank savings account, a personal mutual fund account, or a brokerage account (which you may use to buy and sell stocks and other investments). With a 401(k), you defer paying taxes on your investment earnings until you withdraw the money.

Figure 4-1 shows how tax-deferred compounding lets your money grow faster than it would in a taxable account. It compares the results of investing $7,500 at a 9 percent return in a tax-deferred account with investing $5,050 in a taxable account ($5,050 = $7,500 less income tax) at a 9 percent return.

Gets you matching funds from your employer

Whoever said there’s no such thing as a free lunch didn’t know about employer matching contributions — money that your employer contributes to your 401(k) if you contribute to the plan. (Not all employers make this type of contribution, but many do.)

The most common formula is for the employer to put in 50 cents for every dollar you contribute up to 6 percent of your salary. Employers may make higher (dollar-for-dollar, for example) or lower (25 cents on the dollar, for example) matching contributions and may match higher or lower percentages of salary. There’s no set rule, and some employers are more generous than others. But after an employer sets the formula for the matching contribution, it must meet the commitment until it amends the plan document unless the document permits the employer to make variable employer matching contributions. (The plan document is the official document detailing the plan’s rules.)

So, if your employer puts in 50 cents for every dollar you put in up to 6 percent of your salary, the most your employer will contribute is half of 6 percent, or 3 percent of your salary. You get this full 3 percent only if you contribute 6 percent or more of your salary.

For a concrete example, say you earn $50,000 a year. Six percent of your salary is $3,000. For every dollar you contribute to your 401(k) plan up to $3,000, your employer will contribute 50 cents. So, if you contribute $3,000, your employer contributes an additional $1,500, and you end up with $4,500 after only contributing $3,000 of your own money. However, if you contribute only $1,000, your employer contributes just $500, and you miss out on $1,000 in employer contributions.

How much will your employer contribute if you put in $4,000? If you answered $2,000, or 50 percent of your contribution, unfortunately you’re wrong. If you contribute $4,000, your employer still only contributes $1,500 if the matching funds apply only to $3,000, or 6 percent of your salary. (Yes, it was a bit of a trick question, but I don’t want you to be disappointed.)

You can also include your employer’s contribution when determining how much you should be saving for retirement. Suppose you earn $50,000 and want to put aside 10 percent in your 401(k). If your employer contributes up to 3 percent of your salary as a match, you need to contribute only 7 percent of your salary to achieve your 10 percent savings goal. You pay no taxes on the 3 percent employer contribution until you withdraw it from the 401(k), so the math works out as follows:

An employer matching contribution gives you an incentive to save, and it can give your savings a powerful boost. It makes sense for you to contribute at least the full amount that your employer will match.

You typically have to work for your employer for a certain period of time before you can leave the company without losing your employer’s contributions. I talk about that in the upcoming “Vesting: When Your Employer’s Contribution Is Yours to Keep” section later in this chapter.

The employer matching contribution can be the single most important feature of your 401(k) plan. The more you get from your employer, the less you have to save out of your own paycheck to achieve an adequate level of retirement income. In fact, if your employer offers a matching contribution, make sure that you contribute enough to your plan to get it all. If you don’t, this money will be lost to you. Keep in mind that it’s easier to contribute the amount needed to get the full employer matching contribution if you utilize pre-tax rather than Roth contributions.

Note: Some employers make what’s called a variable or discretionary matching contribution — a hybrid of profit-sharing and matching contributions. You have to contribute to your 401(k) to get it, as with an ordinary matching contribution, but the amount of the contribution varies at the discretion of your company. For example, the amount of your matching contribution may depend on the success of your company from one year to the next.

Makes room for a little something extra: Employer non-matching contribution

Some employers contribute to their employees’ 401(k) accounts (or to another plan) whether the employee contributes or not in what’s called a non-matching contribution. For example, your employer may deposit a profit-sharing contribution into the 401(k) on your behalf, either alone or in addition to a matching contribution. In a good year, for example, your employer may contribute 5 percent of each eligible employee’s pay as a profit-sharing contribution, plus a 25 percent of 401k deferral or 50 percent of 401k deferral matching contribution. You get the 5 percent no matter what, but you only get the additional matching contribution if you put some of your salary into the plan. In a bad year, the company may only make the matching contribution and forgo the profit-sharing contribution, or it may even forgo both contributions!

A company may also make a non-matching employer contribution that’s not based on its financial results. The employer may contribute a specific percentage of your pay each year — typically between 3 and 5 percent — regardless of whether the company does well. A non-matching employer contribution is frequently used when a company has discontinued a defined-benefit pension plan in favor of a defined-contribution arrangement including a cash-balance plan.

Automatic contributions may also be made in what’s called a Safe Harbor 401(k) or a Qualified Automatic Contributions Arrangement (QACA). These are two types of 401(k) plans that don’t have to pass certain federal nondiscrimination tests that are part of the law governing 401(k)s. Details about all types of 401(k) plans are included in Part 5.

Allows you to save without tears

A big benefit of signing up for your 401(k) plan is that you don’t have to think about the fact that you’re saving. “Out of sight, out of mind” is what happens to most people — they don’t even miss the money, because it’s taken out of their paycheck before they have a chance to spend it.

This semi-forced savings is one of the most valuable benefits of 401(k) plans. The payroll deduction has the power to convert spenders into savers. Most people are unable to save over a long period of time if they have to physically write the check or make the deposit each pay period. Saving becomes the last, not the first, priority. Many participants have said that the 401(k) has helped them save thousands of dollars that they otherwise would have spent carelessly.

It’s a good idea to increase your 401(k) contributions if you get a raise or a bonus. In fact, do it right away so that you don’t get used to spending the extra money.

Vesting of employer contributions

Employer contributions, whether matching or non-matching, must generally become yours to keep in one of the following two ways:

• All at once on a specified date within three years
• Gradually over six years

The first method is known as cliff vesting. With this method, you go from 0 to 100 percent vested after three years of service, at the most (the period can be shorter). The second is called graded vesting, or graduated vesting. With this method, you must go from 0 to 100 percent vested by increases of 20 percent over a period of six years at the most.

Table 4-2 shows a comparison of the two vesting schedules, looking at the maximum number of years of service that an employer can generally require.

An employer may choose a faster vesting schedule (and may even choose to have your matching contributions 100 percent vested at all times.

Making exceptions (You knew this was coming, right?)

A few other situations may cause immediate vesting of matching and non-matching employer contributions no matter how many years you have worked at the company. These situations are as follows:

• If your employer terminates your 401(k) plan
• If you reach normal retirement age (an age defined by the plan, but usually age 65)
• If you die before you leave the company
• If you become disabled, as defined in the plan
• If you’re among a substantial portion (such as more than 20 percent) of plan participants who are laid off due to the closing of a plant or division, or are otherwise part of a large layoff
• If your employer needs to make contributions to pass one of the nondiscrimination tests for a regular 401(k)

Employer contributions to a Safe Harbor 401(k) must be fully vested at all times. Employer contributions to a QACA 401(k) must be fully vested after two years.

To find out which rules apply to you, check your summary plan description.

Meeting minimum standards

A federal law called ERISA, the Employee Retirement Income Security Act, governs 401(k) plans. Passed in 1974, ERISA sets minimum standards for retirement plans offered by private-sector companies. Some nonprofits also follow ERISA rules, but local, state, and federal government retirement plans, as well as church plans, don’t have to.

ERISA requirements include

• Providing information to you about plan features on a regular basis, including a summary plan description outlining the plan’s main rules, when you enroll in the plan and periodically thereafter.
• Defining how long you may be required to work before being able to sign up for the plan or before employer contributions to the plan are yours to keep if you leave your job.
• Detailing requirements for the plan fiduciary, essentially including anyone at your company or the plan provider who has control over the investment choices in the plan. (A fiduciary who breaks the rules may be sued by participants.)

This last point, fiduciary responsibility, is important to understand. Essentially, it means that anyone who has a decision-making role in your 401(k) plan’s investments is legally bound to make those decisions in the best interests of the plan participants (you and your co-workers), and not in the best interest of the company, the plan provider, or the fiduciary’s cousin Joe. For example, the committee in charge of choosing a 401(k) provider shouldn’t choose Bank XYZ just because the company president’s cousin runs the bank.

But this doesn’t necessarily mean that you can sue your employer if your 401(k) doesn’t do well. (Keep in mind that lawsuits are often costly and won’t endear you to your employer.) If you lose most of your money because you make bad investment decisions or the stock market takes a nosedive, but your employer has followed ERISA rules, your employer isn’t liable. Your employer may gain limited protection through something called 404(c). Without going into too much detail, Section 404(c) of ERISA requires your employer to provide you with specific information about your plan, including information about the investment options, and allows you to make changes in your investments frequently enough to respond to ups and downs in the market. In return, you assume liability for your investment results.

Avoiding losses in bankruptcy

Many people wonder whether their 401(k) money is at risk if their employer goes out of business. The answer is usually no, with a few caveats:

• If the money is in investments that are tied to your employer, such as company stock, and the employer goes bankrupt, you may lose your money. (This is a compelling argument for you to limit the amount of your 401(k) that you invest in a single stock.)

• In the case of fraud or wrongdoing by your employer or the trustee of the 401(k) account, your money may be at risk. (The trustee would be personally liable to return your money, but that’s no help if they have disappeared.)

  These situations are rare; what’s more, your employer is required to buy a type of insurance — a fidelity bond — when it sets up the plan that may enable you to recoup at least some of your money in the event of dishonesty. (Fidelity bonds generally cover 10 percent of the amount in the entire plan, or $500,000, whichever amount is smaller.)

• Part of your money may be lost if your employer goes out of business or declares bankruptcy before depositing your contributions into the trust fund that receives the 401(k) money that is deducted from your paycheck.

Federal law says that if you declare personal bankruptcy, your creditors generally can’t touch your 401(k). They may be able to get at your other savings, but your 401(k) should be protected. Exceptions include if you owe money to the IRS or if a court has ordered you to give the money to your ex-spouse as part of a divorce settlement. In both of those cases, your 401(k) money is vulnerable.

Earning more may mean contributing less

If you earn enough to qualify as a highly compensated employee, your contributions to your 401(k) plan may be limited to only a few percent of your salary. Many 401(k) plans are required to pass nondiscrimination tests each year to make sure that highly paid employees as a group aren’t contributing a lot more to the plan than their lower-paid colleagues. In requiring these tests, Congress is looking out for the little guy and gal. Chapter 12 explains how these tests work and who qualifies as “highly compensated.”

Being at the mercy of your plan

A well-administered, well-chosen, flexible 401(k) plan can be a wonderful benefit. A poorly administered plan with bad investment choices and little flexibility can be a nightmare. I’ve heard stories of companies that don’t invest employee contributions on time or that take money from the plan; companies that don’t let employees contribute the maximum permitted; and companies where employees pay useless fees for a plan because the managers who set it up were incompetent, uninformed, or even criminals.

In most cases, the tax benefit of a 401(k) is a good enough reason to take advantage of the plan offered by your employer. However, if the investments offered by the plan are truly bad, the fees charged are exorbitant, or the administration of the plan is questionable, you may be better off investing your retirement money elsewhere until you have a better 401(k).