FINALLY, THAT FULL-TIME JOByou worked so hard to earn throughmany years of higher education isoffered to you. You hastily accept theoffer and look forward to getting yourfirst paycheck. Once you start your job,you are given a slew of documents thatcover all of your personal information,taxes, automatic deposit, and the401(k).You may have heard of a 401(k)plan, but how does it work?
A traditional 401(k) plan allows eligibleemployees to make pre-tax electivedeferrals through payroll deductionsand invest that money using variousinvestment vehicles during the courseof their employment.One of the biggestadvantages of participatingin a 401(k)plan is the ability todefer paying taxesuntil you withdrawthe money. Reviewthe Table for a comparison.
This hypothetical example illustratesan 8% rate of return on a $4000 annualinvestment for 40 years. If you werein the 25% tax bracket, you would seethat after 20 years of investing $4000annually, tax deferral would putapproximately 27% more in theaccount than if the earnings were taxedeach year. With a 401(k), if you tookwithdrawals at the end of 40 years, youwould owe income taxes. If you withdrewthe money all at once and paid thetaxes at the 35% rate, you would end upwith $71,240 more than you wouldhave with a taxable account.Lower tax rateson capital gains anddividends may resultin more favorable returnson taxable investments,thereby reducingthe differencein performance betweenthe accountsshown. You shouldconsider your personalinvestment horizonand income tax brackets,both current andanticipated, when making an investmentdecision.
Other details within the structure ofa 401(k) that you should be aware ofinclude:
•Employee Salary Deferral Limits—For 2006, you are allowed tocontribute $15,000. Amounts areindexed for inflation in the year2007 in $500 increments.
•Matching—Not all employersmake matching contributions,and the companies that do maycontribute at different levels. Atypical match may be 25% to 50%of the employee's contribution upto a certain level.
•Vesting—Employee contributionsare always 100% vested, while theemployer's contribution is subjectto a vesting schedule. It typicallytakes 3 to 5 years to be fully vestedand earn the full portion of youremployer contributions.
•Investment Options—Each plan isdesigned to give you the ability todiversify your money. A typical401(k) may have company stockoffered along with various otherinvestment options. It is importantto consider your risk tolerance. Doyou want to be a conservative,moderate, or aggressive investor?Ask questions about the investments,such as the past investmentperformance and how much itcosts each year to own it before youcommit your money to it.
•Rebalancing—Your investment allocationwill change over time as themarkets shift. In order to keep inline with your overall strategy, it isimportant to rebalance your portfolio.Many plans now offer an automaticfeature that will rebalance theaccount on a semiannual or annualbasis, or you can do it manually.
A substantial number of companieshave adopted 401(k) plans in recentyears. Visit individual pharmacy Websites to find out more detailed information.To learn more about 401(k) plans,visit www.irs.gov and search for "Topic424" or visit the US Department ofLabor site at www.dol.gov.
Mr. Laudien is a financial consultant with A.G. Edwards & Sons Inc, inPrinceton, NJ, Member SIPC. Harold Laudien. Mr. Laudien welcomes questions or comments.For more information, please contact him at800-722-3933 or visit www.agedwards.com/fc/harold.laudien.