CHAPTER 1

Getting to Know Your 401(k)

DO YOU EVER wake up at night worried about the financial setbacks you'rehaving with your 401(k) plan in this chaotic economy? Does it aggravate you whenyour plan's value seems to be going in the wrong direction—down? The stockmarket nosedive shown in Figure 1.1 on the following page came on theheels of the 2008 recession and devastated many 401(k) plans. The figure showswhat happened to the average price of a stock on the New York and NASDQ StockExchanges from March 2008 through March 2009.

Many investors had made what they thought were good investments only to see asignificant drop in the value of their accounts in 2008 and well into 2009. Someblamed the 401(k) itself, but that's like shooting the messenger who brings badnews. If you're willing to take the time to really get to know what's insideyour 401(k), then you can start growing it into a nest egg that will help youretire comfortably.

How 401(k)s Work

Employer-sponsored 401(k) plans are retirement savings plans that were createdby the Internal Revenue Service (IRS) in 1978. They allow you to put some ofyour income away now to use later when you need it for retirement. To motivatepeople to start saving in their 401(k) plans, the federal government, in itsinfinite wisdom, created tax breaks for participants.

The plans rapidly grew in popularity when employees discovered that the plansallowed their employers to make tax-sheltered contributions directly into their401(k) accounts. In addition, they liked that 401(k) plans were more portablethan traditional pension plans because they could easily be moved from oneemployer to the next. Employers also liked 401(k)s because they were lessexpensive to fund than defined-benefit retirement plans and easier toadminister.

When you elect to participate in your employer's 401(k) program, you must agreeto deposit into the plan some amount of money from your paycheck. You determinethe amount to be deposited. Some employers match all or part of yourcontributions. You don't pay federal income tax on contributions until youwithdraw your money. What your 401(k) will be worth when you retire depends onthree basic factors: how much you and your employer contributed into the plan,what rate of return you realized from the investments you made, and the lengthof time your money remained in the plan before you withdrew it.

The Employee Retirement Income Security Act (ERISA) is the federal law that setsthe standards for employee retirement plans, including 401(k)s. Employers arerequired to provide to their employees documentation that describes the dailyoperation and benefits of their 401(k) plan, identifies the trust fund thatholds their employees' accounts, and keeps them up-to-date on their accountbalance, deposits, and earnings.

The Economy and Your Future

Now that the first decade of the twenty-first century is over, what's in storefor the second decade and how will it affect your retirement? For one thing,we've all inherited a mountain of private and public debt. Consumer spendingwill no longer get a steroidal fix from cheap loans and cashed-out home equity.Lending terms will be significantly tougher for both individuals and businessesalike.

Global competition will be fierce in manufacturing and services, keeping a lidon U.S. wages. The mountain of government debt incurring will inevitably resultin higher inflation, more taxes, and higher interest rates. Foreign creditorssuch as China will keep lending us money, but they'll demand a premium price fortheir loans. All of these economic events will dampen corporate profits,restrain stock prices, and hamper employers' ability to match employee 401(k)contributions.

The good news is that on average we'll live twenty years longer than ourparents. Unfortunately, that puts more pressure on retirement accounts. If youplan to retire in your sixties or earlier, you could live thirty or more yearsin retirement. So it's never too early or late to plan for a retirement that maylast longer than your working career.

The age you retire is up to you, regardless of your income level. The securityof your retirement will depend on focusing your attention on your financialgoals. Your 401(k) plan is more important now than it ever was. Fortunately, thelaws affecting 401(k) plans make it easier for Americans to save, but they alsomake workers more responsible for their own retirements.

What's in Your Plan?

Your 401(k) plan is a tax-deferred savings account similar to an IndividualRetirement Account (IRA) with several important exceptions. Your employer ownsyour 401(k) plan, which is an important distinction you need to understand. Allemployees are allowed to participate in their company's plan. The money that youcontribute into your part of the 401(k) plan belongs to you, and anycontribution that your employer makes on your behalf belongs to you once you'vesatisfied vesting conditions set by your employer.

Tax-exempt contributions to your 401(k) come directly from your paycheck up to$15,500, $22,000 if you're 50 or older, each year. You can contribute to your401(k) plan only while you're still working for the employer that set it up. Ifyou change employers and your new employer doesn't have a 401(k) plan, you canconvert it to an IRA. If your new employer has a 401(k) plan, you can transferit over into your new employer's plan.

Some employers contribute to their employees' 401(k) plans as their way ofencouraging their workers to participate in their retirement plan. Employerschoose the amount they're willing to contribute as part of a profit-sharingprogram or routinely make matching contributions that have nothing to do withthe company's profit. Matching contributions are made at a specified percentageof each employee's contribution. In some cases, employees are not 100 percentvested in matching contributions until they have been in the program for aspecified period of time. However, more and more employers are offeringsafe-harbor 401(k) plans, which make their contributions 100 percent vested(i.e., the money is yours) when they are made. Your own contributions are always100 percent vested.

An employer's...