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Personal Finance

Nine Fine Reasons Why You Should Contribute To A 401(k) Plan

By Clifton Linton
Writer, mPower

Nine Reasons To Participate In A 401(k) Plan
  • Regular saving becomes automatic
  • You benefit from dollar-cost averaging
  • You get to shelter money from taxes
  • Your retirement money grows at a compound rate
  • If you leave your job you can take your money with you
  • You can put more money in a 401(k) than in an IRA
  • Employers often match all or part of your contributions
  • You may get access to funds that are normally open only to big investors
  • Social Security won't be enough

If you think saving for retirement is tough, consider the story of Janet and Hugh Levaux.

In 1995, Janet (then 30 years old) and her husband, Hugh, (29) had just moved to Los Angeles from Japan. Hugh was a full-time graduate student (read: no income). The couple planned to start a family. And though neither one had saved a dime toward retirement, they were anxious to start.

But they didn't know how to juggle the additional costs of having a child with starting to save up a retirement nest egg.

Then Janet took a job as a reporter with a local newspaper. The company offered a retirement plan that allowed new employees to sign up after just three months. Janet took advantage of this good fortune, and immediately started putting about 3% of her salary into the plan.

When their son was born two years later, Janet's 401(k) contributions were so routine that she didn't even think about stopping them.

"I never thought about the 401(k) because I didn't have to," she says.

So in four years, despite being a one-income household with a new child, the Levauxs managed to sock away $10,000 toward retirement. That's an impressive achievement says Ted Benna, the benefits consultant who designed the first 401(k) plan.

How did they manage to do this?

They used a 401(k) plan. This retirement tool helped them become disciplined savers, reduce their income taxes and save more than they could have with an individual retirement account (IRA). And they're on the road to even more saving - in 1999, Hugh received his graduate degree and took a full-time job with a large corporation, where he is now contributing to a 401(k) as well.

401(k) Availability and Participation are Rising

Year Number of Plans Active Participants
(in thousands)
(in millions)
1985 29,869 10,339 $143,939
1986 37,420 11,559 $182,784
1987 45,054 13,131 $215,477
1988 68,121 15,203 $276,995
1989 83,301 17,337 $357,015
1990 97,614 19,548 $384,854
1991 111,394 19,126 $440,259
1992 139,704 22,404 $552,959
1993 154,527 23,138 $616,316
1994 174,945 25,206 $674,681
1995 200,813 28,061 $863,918
(Source: Pension Welfare Benefit Administration
of U.S. Dept. of Labor)

This same tool is used by about 30 million workers in the U.S. And it is available to many more who don't take advantage of it. Only 80 percent of people eligible to contribute to 401(k) plans actually do so, according to the Profit-Sharing/401(k) Council of America.

Here, in no particular order, are nine fine reasons why you should pat yourself on the back if you are already contributing to a 401(k) plan, or sign up for one if you're not!

Automatic Savings

One of the best features of a 401(k) plan is that the saving becomes automatic.

"What the 401(k) does is … make savings a priority. The money comes off the top," Benna said.

The plans work this way. You figure out how much you want to contribute to your plan, and the money is taken out of your paycheck each pay period. Say you want to contribute $2,000 a year. If you get paid every week, your employer takes out $38.46 before you get your paycheck. You never need to think about writing a check or making a bank transfer.

"I wouldn't have saved the money without it," Janet said. "I wouldn't have had the discipline."

How Much Americans Saved Each Year
From 1994 to 1998
(in billions)
1994 1995 1996 1997 1998
$189.4 $249.4 $274.4 $121 $27.7
(Source: U.S. Department of Commerce)

Americans are poor savers. We're an instant gratification society, and if we have the money we spend it. Personal savings rates fell to 1.2% of disposable personal income in May, according to the U.S. Commerce Department. We haven't fallen that low since the Great Depression.

A 401(k) plan is "the least painful way to save. It converts spenders into savers," says Benna.

Dollar Cost Averaging

401(k) plans let you take advantage of an investment technique called dollar cost averaging.

Here's how it works: over time, as you invest systematically, you will be buying shares at whatever the current market price is. Sometimes, you will buy fewer shares at higher prices. Sometimes you'll buy more shares at lower prices. When you buy more lower-priced shares, that will help bring down the average cost of all your shares. So when share prices rise, you will see profits off that lower base and on a greater number of shares.

Since a 401(k) plan takes the same percentage out of every paycheck, it does the systematic investing for you.

Tax Breaks

Contributing to a 401(k) plan reduces your taxable income. That's right, Uncle Sam lets you put a maximum of $10,000 every year into a 401(k) plan before he starts calculating taxes on your gross income.

If you earn $40,000 annually and stash $2,000 a year (5% of your salary) in a 401(k) plan, the government only collects taxes on gross income of $38,000.

You can also use 401(k) contributions to push yourself into a lower tax bracket, where you pay a lower tax rate.

"It's possible to make 401(k) contributions to drop a tax bracket. I've seen that frequently," said Greg Thurin, District Manager and Personal Financial Advisor with American Express Financial Services.

But, wait, there's more. Taxes are deferred on all the profits (interest) you make while the money is in the 401(k) plan. You do eventually have to pay the piper, when you pull the money out at retirement. But by the time you quit work, your annual income could be a lot lower. So, you may pay taxes at a lower rate.

If you take money out of the plan before you reach age 59½, you have to pay a 10% penalty tax in addition to income tax on the money and profits. However, if you stop working at age 55 or later you will not have to pay the penalty, though you will still owe taxes.

Interest Compounding

Let's go back to Janet and Hugh and see what would happen if they left their money in the account.

Assume they don't add any more money to the plan, and what they have earns 8% interest. Over the three decades until the Levaux's reach retirement age, that $10,000 could grow tenfold, to $100,000, through a process known as compounding.

When earnings are compounded, they're rolled back into your account so that the next time you earn interest it's on the new whole amount. In effect, you earn interest on your interest, and delaying paying taxes on it all.

"The easiest way to think of it is with the rule of sevens," said Jonathan Berk, assistant professor of finance at the Haas School of Business at the University of California at Berkeley. "If you put $100 into an account and compound it, it doubles every seven years."

That's a pretty rough guide, he says, but the point is well-made. Each time profits are calculated your money works for you even harder. The benefits are even greater if you continue to contribute to the plan throughout your working life.

As renowned physicist Albert Einstein is credited with saying, "the greatest invention in the world is compound interest."

Higher Contributions Than An IRA

In the 1980s, it seemed that just about everyone opened an IRA. That was a good thing because many Americans started saving for retirement.

But IRAs have limitations. One is that the government allows you to only save $2,000 a year, tax-deferred. (And depending on your income level, you may not be able to deduct all or even part of your contributions from your gross income.) On the other hand, you can save up to $10,000, tax-deferred, in a 401(k), and your contributions are always tax deductible.

And things may get better. It's likely that the maximum contribution to a 401(k) plan could rise to $10,500 in 2000, Benna says. And Congress is considering rules to raise the contribution limits for IRAs.

Employers Often Match Your Savings

If you work for the right employer, a real bonus of a 401(k) plan is your company's matching contribution. In short, it's free money.

"(No other investment) can match a 401(k) plan," said Michael Schuster, managing partner with Competitive Human Resource Strategies, an industry consultant. "You can get similar things with an IRA. But no other plans have the employer match."

About 87% of companies that offer 401(k) plans match employees' contributions by some percentage, a 1996 survey by Watson Wyatt says. The average match is 50 cents on the dollar on the first 6% of pay.

What's more, the employer match is also tax deferred.

But there's a hitch. You generally have to work at your company for a few years before the employer contribution actually belongs to you, even though it does have to be deposited to your account regularly. This is known as vesting. Some companies let you vest a little bit at a time, while others only vest you fully after a set number of years.

Portability, Or You Can Take It With You

Even if your employer match hasn't vested, you still own your contributions. Unlike traditional pension plans, you can take the money in a 401(k) with you if you switch jobs. There is a caveat. The government gives you 60 days to find a new tax-sheltered plan to put the money in. You can put it into your new employer's 401(k) plan, if the plan allows rollovers, or roll the money into what's known as a rollover IRA.

If you miss that 60-day deadline, however, you have to pay taxes on that money and a 10% penalty if you are under 59 ½. Your best bet is to do a direct rollover from one plan to the next, and never have the check made out to you.

Professional Advice

401(k) plans offer ordinary people the opportunity to invest in funds that might otherwise be open only to big-money investors. Many mutual fund companies require hefty minimum balances to open accounts. But some 401(k) plans offer participants the opportunity to invest in the same top funds, for as much (or little) as they want -- $50 or $5,000!

Social Security Won't Be Enough

Financial planners generally say you'll need between 70-90% of your pre-retirement income to live comfortably in retirement. Where is that money going to come from? Social Security won't do it alone.

Saving a little bit each month in your 401(k) should help you to have enough money to retire comfortably when the time comes.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.
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