A 401k is a retirement plan that permits employees to contribute their pretax dollars to a financial account. These contributions are then invested in mutual funds, stocks and bonds.
There are several advantages to contributing to a 401k plan. First, 401k contributions and earnings are tax deferred. Second, employers often match your contributions to your 401k account. Third, you can borrow money from your 401k account. The interest rate to borrow from a 401k is typically much lower than bank rates. However, there are some pitfalls associated with borrowing against your 401k account, despite the low interest rate.
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401k plans were introduced by Congress to the Internal Revenue Code in 1978. This section in the code is called 401k, hence the name 401k retirement plan. The plan allows employees to route portions of their salaries into retirement accounts, which will not be taxed. The 401k plan was first intended for executives, but it became popular with employees at all levels.
By 1984, about 18,000 companies offered 401k plans. In the same year, Congress passed a bill to limit the maximum contribution to the plans so they do not overly favor employees with high salaries.
Currently, there are about 450,000 companies with 401k plans in the U.S. Most companies have 401k matching policies. For instance, a company may decide to match up to 5 percent of an employee's monthly income.
401k plans benefit employees and employers. Rather having to pay for pension contributions, a company only has to pay for administrative costs of the 401k plan. Some of the costs can be passed on to participating employees. One of the dangers of the 401k plan is the uncertainties associated with the investments. Some companies encourage 401k participants to invest in the employer. A prime example is Enron. Enron employees lost all the money invested in Enron stocks following the bankruptcy.
A 401k allows participants to save their money until they reach retirement age, which is at least 59 1/2 years old. The participants can also choose to invest their 401k savings into stocks, mutual funds and bonds. Both earnings and contributions are tax-free.
During the saving process, you can choose to borrow from your 401k plan for personal purposes such as buying houses, paying for medical expenses, or paying for college tuition. The loan has to be paid back with interest. The advantages include no credit check, no waiting for approval, and lower interest rates in comparison to bank's interest rates. Furthermore, the interest is paid back to your 401k account.
The conditions for borrowing vary among plans. Some 401k plans allow you to borrow for any reason. Most plans only allow participants to borrow up to half of their vested account, at the maximum of $50,000.
According to federal law, the interest rate has to be set at a reasonable value. Typically, this rate is fixed at prime rate, which is the rate that banks offer to their favored customers, plus 1 percent. This interest rate is typically lower than what banks may offer you.
Normally, you have to repay the loan in 15 years if it was used to buy your first house or five years for other reasons.
Each company has its own unique 401k policy. When you change jobs, your 401k will be affected. In most cases, you can roll over your savings into a new 401k account. This has to be done within 60 days, otherwise, your savings might be subject to tax. However, some companies require cash-out. Alternatively, you can roll over your 401k plan into IRS accounts.
The maximum limit you can contribute to your 401k plan in 2008 is $15,500. This limit is subjected to change in the future due to inflation. If you are 50 years old or older, you can contribute an additional "catch-up" contribution up to $5,000. The total contribution to the 401k from you and your employer should not exceed $45,500 in 2008.
If you are self-employed, the rules for the 401k plan are different. In addition to the standard maximum $15,000 and the catch-up contribution of $5,000 if you are 50 or older, you can also have the so-called profit-sharing contribution of up to 25 percent of eligible pay without reduction for salary deferrals. These individual plans, also known as Solo-401k plans, have become popular lately.
Despite the low interest rate, taking a 401k loan may lead to significant financial loss. First, since the interest rate is lower, it would mean also that the account will earn less than 401k investments. Second, you will lose compound interest and dividends if you had not borrowed the money. Third, payments on the loan are not tax-deferred.
For a young worker (30 to 35 years old), borrowing $30,000 from his 401k account may lead to a loss of more than $500,000-$600,000 in retirement income.
Borrowing from a 401k account also comes with many restrictions. If you default on the loan, you have to pay both federal and state income taxes on the loan. If you are younger than 59.5 years old, the defaulted loan is considered to be an early withdrawal, and you have to pay a penalty of 10 percent. If you change jobs, you need to pay the loan back within 90 days, otherwise the loan will be regarded as in default.
The profits on a 401k depend on the types of investments you choose. Between 1970 and 2006, the annual return rate of the S&P 500 was 11.5 percent. The highest and lowest annual return rates are 61 percent and -39 percent, respectively. Your performance may be higher or lower than the S&P 500, depending how conservative you are about investing. Diversification is critical in minimizing your financial losses.
Borrowing from your 401k account may sound like an attractive option, however, even in a slow economy, it does not make sense financially.