FINALLY, THAT FULL-TIME JOB you worked so hard to earn through many years of higher education is offered to you. You hastily accept the offer and look forward to getting your first paycheck. Once you start your job, you are given a slew of documents that cover all of your personal information, taxes, automatic deposit, and the 401(k).You may have heard of a 401(k) plan, but how does it work?
A traditional 401(k) plan allows eligible employees to make pre-tax elective deferrals through payroll deductions and invest that money using various investment vehicles during the course of their employment. One of the biggest advantages of participating in a 401(k) plan is the ability to defer paying taxes until you withdraw the money. Review the Table for a comparison.
This hypothetical example illustrates an 8% rate of return on a $4000 annual investment for 40 years. If you were in the 25% tax bracket, you would see that after 20 years of investing $4000 annually, tax deferral would put approximately 27% more in the account than if the earnings were taxed each year. With a 401(k), if you took withdrawals at the end of 40 years, you would owe income taxes. If you withdrew the money all at once and paid the taxes at the 35% rate, you would end up with $71,240 more than you would have with a taxable account. Lower tax rates on capital gains and dividends may result in more favorable returns on taxable investments, thereby reducing the difference in performance between the accounts shown. You should consider your personal investment horizon and income tax brackets, both current and anticipated, when making an investment decision.
Other details within the structure of a 401(k) that you should be aware of include:
•Employee Salary Deferral LimitsFor 2006, you are allowed to contribute $15,000. Amounts are indexed for inflation in the year 2007 in $500 increments.
•MatchingNot all employers make matching contributions, and the companies that do may contribute at different levels. A typical match may be 25% to 50% of the employee's contribution up to a certain level.
•VestingEmployee contributions are always 100% vested, while the employer's contribution is subject to a vesting schedule. It typically takes 3 to 5 years to be fully vested and earn the full portion of your employer contributions.
•Investment OptionsEach plan is designed to give you the ability to diversify your money. A typical 401(k) may have company stock offered along with various other investment options. It is important to consider your risk tolerance. Do you want to be a conservative, moderate, or aggressive investor? Ask questions about the investments, such as the past investment performance and how much it costs each year to own it before you commit your money to it.
•RebalancingYour investment allocation will change over time as the markets shift. In order to keep in line with your overall strategy, it is important to rebalance your portfolio. Many plans now offer an automatic feature that will rebalance the account on a semiannual or annual basis, or you can do it manually.
A substantial number of companies have adopted 401(k) plans in recent years. Visit individual pharmacy Web sites to find out more detailed information. To learn more about 401(k) plans, visit www.irs.gov and search for "Topic 424" or visit the US Department of Labor site at www.dol.gov.
Mr. Laudien is a financial consultant with A.G. Edwards & Sons Inc, in Princeton, NJ, Member SIPC. Harold Laudien. Mr. Laudien welcomes questions or comments. For more information, please contact him at 800-722-3933 or visit www.agedwards.com/fc/harold.laudien.