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A Commonsense Guide to Your 401(k)

A Commonsense Guide to Your 401(k)

by Mary Rowland

In an accessible, step-by-step format, Mary Rowland explains how to get the most out of a 401(k) and use it as the basis of a lifetime of financial planning.


In an accessible, step-by-step format, Mary Rowland explains how to get the most out of a 401(k) and use it as the basis of a lifetime of financial planning.

Editorial Reviews

Don Phillips
A wonderful primer that guides even novice investors toward becoming more confident 401(k) investors. Everyone with access to a 401(k) account should read this book.

— President, Morningstar Mutual Funds

Laura Tarbox
If you are ready to take control of your financial destiny, you would be well advised to read this book.

— CFP, Tarbox Equity

Product Details

Publication date:
Bloomberg Series , #55
Edition description:
1 ED
Product dimensions:
4.60(w) x 8.13(h) x 0.86(d)

Read an Excerpt

Chapter One



The other day, a friend of mine was remembering his father, a hurried man who denied himself small pleasures to focus on the task at hand. The pleasures would come later, his father always said, when he retired. Then he would golf, fish, read, swim. He retired at 60 and moved from Chicago to Florida, where he built a house with a pool, bought golf clubs, fishing equipment—the works. You know the story. He didn't golf or fish or swim or read. He was bored to death. Fortunately, though, my friend's father saw that the Florida life was a mistake for him. He moved to the San Francisco Bay area, where he worked part time and puttered and tinkered the rest of the time for the remainder of his life.

    Lest you think I'm opposed to relaxing and a promoter of workaholism, let me tell you another story. Stan Breitbard retired as national director of Price Waterhouse in 1995 at the age of 56. Stan wanted a change and fully expected to find another full-time position somewhere near his home in Los Angeles. It didn't work out that way, though.

    I was talking to Stan one day in the spring of 1997 about how retirement was going. He had developed a plan for teaching personal finance to students pursuing their master's degrees in business administration. He'd taught the course at Berkeley and loved doing it. He'd also joined a reading circle—he was the only man, he said—and was reading and discussing the classics as well as modern fiction. He also had plans to build on hislifelong passion for James Joyce by compiling a bibliography of works by and about the author and by forming a Ulysses reading group. And he was spending a great deal of time on the Internet, pursuing his interests in investing and financial planning.

    But what about the second career? Well, Stan replied, it just wasn't appealing anymore. There were too many other things he wanted to do. Do you still need to do a financial plan—a career plan, a life plan—in retirement? I wanted to know. "Of course," Stan said. "I rethink what I'm doing constantly. I think about where I want to live, what I want to do, how I want to work."

    My point is an obvious one. Your working life and your retirement life are not two distinct phases, one drudgery and one pleasure. Those who work successfully and retire successfully knit the two together, almost seamlessly. But it is not easy. It requires a great deal of thought—about who you are, what you want, what you enjoy, where you're going. And a great deal of planning. In a sense, this is the very toughest part of financial planning because it requires facing up to who you are and what you dream about. Top financial planners, like Stan Breitbard, say they have lost clients because they've asked them to face these questions.

    Stan asked his MBA students at Berkeley to draw up a five-year financial plan for themselves. The students fell into three groups. The first concentrated on simple bookkeeping tasks: Paying off bills, developing a filing system, getting organized. The second group focused on saving and investing and some longer-term goals. But the third group looked at real financial planning—dreaming dreams and thinking about where they would go in life and how they would get there.

    You wouldn't be reading a 401(k) book if you weren't thinking about your retirement—or perhaps worrying about your retirement. So much of what we read is designed to make us frightened that we won't have enough money to retire. When you think of retirement, I urge you to think of it in the broadest possible terms. Don't think of it as a compromise. Spin out all your dreams. Stretch to include everything in life that you might want to be. And then think about how you might accomplish it.



Wherever you are in your working life, take a little time now to reflect on what you can expect from a job or career—and what you can expect later, when it's over. Twenty years from now—or even 10 years from now—work and retirement will not be such distinct phases of life as they are for today's retirees.

    Work life in America was redefined in the 1980s and 1990s as more than 43 million jobs were erased, a number that comes from a New York Times analysis of U.S. Department of Labor statistics. Many new jobs appeared. But too many that were lost belonged to higher-paid, white-collar workers—those employees who looked forward to a pension and a comfortable retirement.

    These middle managers were replaced by contract workers. "Consultant" is the euphemism for many of those who today earn low wages and receive no benefits. The Times told the story of Steven A. Holthausen, who was laid off from his $1,000-a-week job as a bank loan officer at age 50 and felt lucky to land a job dispensing tourist information off Interstate 95 in Connecticut.

    This revolutionary change in the workplace will be followed by a revolutionary change in retirement. Certainly Holthausen does not expect a rich pension. This should not depress you. But it should make you think about what you will do with your work life and your nonwork life and how you might merge them together in a way that is satisfying for you. Charles Handy, a sometime professor and author on organizational change, made some suggestions in his book The Age of Unreason (Harvard Business School Press). When Handy wrote in 1990 that working at a corporation is no longer a viable alternative for most people, it seemed startling. Less than a decade later, it seems quite clear.

    Handy, who began his career as an oil executive and then became a teacher and writer, predicted that workers in the 21st century will fit into one of three types: managers and technicians who will run the corporations; unskilled clerks and laborers; and creative people like consultants, designers, and others who work on a contract basis. Not only will many of us spend our working lives as self-employed contractors, Handy said, but all of us will work until a much later age. Even those managers and technicians who work as employees will remain in their jobs only until age 55 or so, he said, at which point they will have 15 or 20 more work years.

    To prepare for this future, Handy recommends that you develop a portfolio of skills, services, and products that you can sell to corporations and to others in the marketplace. When his own two children left college, he told them: "I hope you won't look for a job in a corporation." Instead, he advised: "Look for customers. If you have a saleable skill, you can always work."

    Handy's advice is right on target. Demographics play a role too. As we live longer—and enjoy better health—most of us will want to be productive. Whether you are just starting out in your career, you are at midpoint, or you are nearing the finish line, work on skills you need and develop the talents that you have. Retirement at age 55—or even 60 or 65—will no longer be an option for most people working today. Those who have a portfolio of skills will be able to pick and choose what they will do and when they want to do it. For them, a blend of work and leisure can be a pleasure. It will solve the problems of both work and retirement.



Here is the problem for millions of middle managers who were "outplaced" or "downsized" over the past 15 years: They know how to manage people. But no one will pay them to do that anymore. As corporations have become flatter and team management has replaced the management hierarchy, few people are being paid simply to manage other people. If you want to succeed, you must identify something that you can do that commands a fee, or a salary.

    It's not easy for many people to think of what their skills and talents are beyond the title a corporation has given them. "But we all have a lot of neglected talents," says Charles Handy. "It's a matter of redefining yourself. You need help because you've only seen yourself in one light."

    To free up your thinking about what you're good at, Handy suggests that you go to 20 people you know and ask each to tell you one thing you do very well. Handy instructed a 48-year-old advertising executive who had just lost his job to do that exercise. "It was sort of embarrassing," this former adman told Handy. "I got 20 answers and not one of them was advertising." Instead, this man was told that he was very creative, good at organizing teams, presenting ideas, leading people, selecting wines, and recalling historical details. What to do with that?

    This one-time adman set up a business taking people on tours of battlefields and other historical sights and vineyards throughout Europe. "He was able to redefine his whole life," Handy says. "It was a nice example of what you can do with some original thinking." It shows, too, that it pays to stretch far afield when you think about what you do well.

    Consider, too, what outplacement firms do for those who are laid off—or what they used to do when employers allotted bigger budgets to this function. The first step might be to write an autobiography, breaking up your life into chapters: early childhood, grade school, high school, college, first job. When you get to career, think broadly of the tasks you have done rather than what you've been called. People tend to think of their career as their recent job. In fact, even if you have spent your career at one company, you have no doubt had several separate and distinct jobs. Think, too, of particular tasks that you have enjoyed and things you've done well—on the job, in school, or in volunteer projects.

    When people go through this process, they often discover that there was one particular stop in their career where they loved what they were doing. As they moved along, that passion often got lost or misplaced as they became subsumed by corporate politics and the day-to-day demands of earning a living. Thinking through the process helps them rediscover what it was they really liked to do. That's why so many people who go through the painful layoff process later say, "It's the best thing that ever happened to me."

    Even if you are happy in your job now, you need to hone your skills. And no matter what you do well—and what you end up doing—you will need some computer skills. If you have been procrastinating, get going. You need to know how to use the computer and how to find your way around the Internet. Learn what research tools are available and how specialists in your industry use the computer. Lack of familiarity with the computer labels you as a dinosaur. Develop your skills in writing, communications, foreign languages, and mathematics, too. These are skills that you will need in any business—and that will be handy if you work for yourself.



It doesn't have to be today, of course. But sometime in your career, you will work for yourself. Many people dream of owning their own business. Many others are terrified at the prospect. A decade ago the advice was this: Operating your own business requires a big appetite for risk, good organizational skills, rigid self-discipline, the ability to combat loneliness. If you don't have that skill set, you're an employee.

    Forget that. Depending on a paycheck from a corporation is a luxury most Americans cannot afford anymore. Wherever you are in your work life, you should have an escape plan. You need a skill that someone will pay you for. The best way to find out what it is is to think about how you might set up an independent business. There is almost no job—from anesthesiology to zoology—that can't be done on a contract basis. And all kinds of people thrive as entrepreneurs. One of the most important tools you need is a passion for what you do.

    Today many talented, entrepreneurial people move in and out of corporations. They develop their skills working for one or more employers and then set up their own shop—as a designer, consultant, writer, electrician, carpenter, software developer—and develop a roster of clients. Often they find that one client is consuming more and more time and providing more satisfying work. Perhaps they join that company as an employee.

    But there are a couple of differences between this worker and the employee of the 1960s. First, our modern worker has a skill set that is portable. Second, he never becomes lulled into thinking the corporation will take care of him. That notion is ancient history. Workers in the 21st century will need to focus on their own skills and how to develop them rather than on corporate politics and how to stay on the right side of the boss. You should always be on the lookout for ways to develop your own skills: take extra courses, look for opportunities to speak, make presentations or appear on radio or television. Don't back away from difficult assignments. They will help you grow.

    Here are some other factors to consider:

* Risk. Don't brush off the possibility of self-employment just because it scares you to death. Every successful entrepreneur felt exactly the same way. Kristie Strasen, a New York fabric designer, was terrified at the prospect when she left Tandem Mills, a Canadian textile firm, in 1986 to set up her own business. "I realized a long time ago that I'm not the sort of person that does better work with the dogs nipping at my heels," she says. But after more than a decade as a successful designer, she's not looking over her shoulder anymore to see if the wolf is at the door. Putting all your eggs in one basket is risky, too.

* Marketing. Many people with terrific skills simply don't know how to let people know that they're available. Think about how you will do this.

* Fees. You must be able to figure out how to set yours and stick to your guns. When Olimpia Meccia, a jewelry designer, left Tiffany & Company to set up her own business, she found that clients would expect a lower fee if the piece they wanted was simple. "They're still getting all the knowledge I have," she says. "Just because they choose not to use everything I know doesn't mean they don't have to pay for it."

* Professional growth. When you work for yourself, you will have no mentors. You must constantly weigh the relative merits of pumping out more work or, say, attending seminars to learn more about your specialty. You must also choose between projects that pay well but offer little challenge and those that pay less but offer opportunity for growth.



"Boring," I hear you saying. True. And sobering, too. But spend a moment anyway. Working longer will be a necessity for most Americans. But none of us will work forever. We must still save and prepare for the portion of our life when we do not work.

    There are lots of charts, tables, and software programs to help you find out how much money you will need for retirement. Most assume that you will need about 75 to 80 percent of your working income to maintain a comfortable lifestyle in retirement.

    Here is a chart that I like prepared by Steven E. Norwitz, vice president at T. Rowe Price & Associates, the Baltimore-based mutual fund company, because it gives you an idea of what you should have saved depending on how far you are from retirement. For younger people, those numbers seem easier to grapple with. Your savings goal is expressed as a multiple of your current income.

    The chart (at right) also clearly illustrates how you can reach your goal by saving less if you choose a more aggressive investment strategy. Norwitz looked at three different investment strategies. The first is aggressive, with 80 percent invested in stocks and 20 percent in bonds before retirement and 65 percent in stocks, 35 percent in bonds after retirement.

    The moderate strategy assumes a mix of 65 percent in stocks and 35 percent in bonds during working years and 50/50 after retirement. The conservative investor splits his money 50/50 between stocks and bonds during the working years and keeps just 35 percent in stocks during retirement.


0 957%1046%1048%
5 675% 773% 890%
10463% 558% 676%
15307% 393% 505%
20193% 268% 369%
25109% 172% 261%
30 48% 98% 174%
35 3% 42% 105%

    To develop the numbers, Norwitz made the following assumptions:

* that you want to replace 75 percent of your pretax income at retirement and that that amount increases with the inflation rate every year;

* that you save 8 percent of your annual income between now and retirement in a pretax account and that your income grows at the rate of inflation;

* that you will spend 25 years in retirement and use all of the money you have saved at the end of that time period;

* that all distributions are pretax.

    The chart certainly points to the value of starting early and putting money in stocks. It is also sobering. If you earn $75,000 and you are ready to retire, you need a nest egg of about $750,000. If you're there, great. If you're not, don't despair. Few Americans have managed to meet all their financial needs in neat little packages like this. Keep working on it. Start thinking, too, about the transition you will make to your retirement life. If you're far short of your goal, you'll probably need to work a little more and save a little longer.



Calculating retirement needs is not fun. But figuring out what changes you can make might be—particularly if they are nearly effortless. A good retirement software program can help you look at all your assets—retirement accounts like 401(k)s, pension plans, and IRAs as well as the equity in your home, the cash value in your life insurance and other savings and assets you might have—and translate them into retirement income.

    You can plug in your salary and your current rate of savings, and see how much you fall short. Then you can see what happens if you save a little more or if you invest a bit more aggressively. If you are in your twenties, the result of even a tiny change can be startling. But wherever you are, changing your habits just a bit can make a big difference.

    The best place to begin is your company's human resources department. Most employers want their employees to grasp the enormity of the need to save for retirement. And they're doing what they can to help. Many of them provide tools that are customized to use your company's 401(k) plan and pension to help you see what you can expect from them and where you might fall short.

    For example, the IBM Corp., a traditional leader in the employee benefits area, issued a piece of software to every employee in 1991 to help him or her chart a course to retirement by manipulating budget assumptions and pension options. IBM's purpose was two-fold. It wanted to help employees plan. But it also wanted to make certain they didn't stay around too long. At the time, IBM had built an enviable reputation for avoiding layoffs. And the company was still hoping to avoid them. (We all know that didn't work out.)

    The software package showed employees what they could expect in inflation-adjusted dollars from each portion of the company's retirement plan as well as from Social Security. It also helped them determine how they could change the picture by saving, say, 1 percent more of salary or taking a little bit more investment risk to produce an additional 1 percentage point in return. It showed how much of a gap an employee faced between expected income and what might be needed at retirement. And it suggested ways to close the gap, such as contributing more to a 401(k) plan. The IBM story is an interesting one because it illustrates how what was once the mightiest of companies was forced to trim benefits to stay in the game—and how it tried to help employees as it did so.

    In the years since IBM introduced its package, most major employers have developed something similar. Check to see if your employer has one. If not, consider one of the good—but inexpensive—products from one of the leading mutual fund companies. Fidelity Investments (800-544-8888), T. Rowe Price (800-638-5660), and the Vanguard Group (800-662-7447) each offer a quality software package for just $15. Of course, the programs feature the mutual funds from that particular fund group. But you don't have to buy them.

    You might also check on the World Wide Web for retirement planning worksheets. The Mutual Fund Education Alliance, a trade group for funds that are sold directly over the phone or through the mail—like those listed above—provides retirement worksheets at its Web site (www.mfea.com), as well as links to the Web sites of other mutual fund companies.

    It is sobering to see just how much money it will cost to support yourself without any employment income coming in. But don't get discouraged about it. Start saving. Learn about investing. And make plans for how you will supplement this nest egg.



Some of today's retirees enjoy rich pension benefits from corporate plans, many of which were set up after World War II to attract workers and to keep them in a booming economy. These plans are called defined benefit plans because they define the annual pension benefit you receive. The employer foots the bill for the entire plan, putting the money aside, investing it, and taking the responsibility for making certain it is available to pay out benefits.

    Defined benefit plans were designed to reward loyal employees who spent their entire careers with one company. The benefit is heavily weighted toward the later working years, when the employee's salary is highest. A good plan should replace about 50 percent of income for an employee with 30 years' service.

    But few Americans at midcareer today have spent their career at a single employer. In recent years, workers over 25 have changed jobs every 5.7 years, on average, according to a retirement study done by the Investment Company Institute, the mutual fund industry trade group, based on figures from the Bureau of Labor Statistics. In fact, many 45-year-olds are not vested in any pension plan at all.

    The benefit from a traditional pension is calculated as a percent of your final salary times years of service with the company. A typical defined benefit plan might provide 1.2 percent to 1.5 percent of the average of your final three years of compensation times your years of service as an annual pension. Suppose your average salary over your last three years of work is $100,000 a year. Then 1.5 percent is $1,500. If you have been with the company for 40 years, your annual pension would be $60,000. Work 25 years and you earn $37,500; five years earns you $7,500.

    So job hopping reduces the benefit substantially. When you leave an employer at age 40, your pension benefit at age 65 will be calculated based on the salary you earned 25 years earlier, with no adjustment for inflation. For example, Dale R. Detlefs spent 18 years with "a large industrial company with an excellent pension plan," leaving when he was 47. When he retired in 1992 at age 65, his pension from this previous employer was "just enough to cover my utility bill," he says.

    To illustrate the penalty for job hoppers, actuary Ethan E. Kra calculated benefits for three employees, each with 40 years of employment, the same final salary, and the same pension benefit formula. The first, who spent all 40 years with the same employer, receives 60 percent of his final salary as a pension benefit. The second, who worked at two employers for 20 years each, receives 39 percent of final salary. The third, who worked at four employers for 10 years each, receives just 31 percent.

    Obviously, there are many more important things that will shape your career decisions than what type of pension you will receive. Still, it is important to understand how benefits in these plans are affected by the salary you earn and your years of service.

    By working longer, you increase the time when you will have a regular income, increase your assets and eventual pension, and decrease the years spent consuming those assets. Federal law mandates that your employer must continue to credit years of service for pension purposes if you work beyond normal retirement age. If you receive salary increases, you will also be increasing your pay for purposes of calculating your pension. The eventual pension increase reflects what is called an "actuarial equivalent," meaning you should get the same amount of money over your expected lifespan no matter when you decide to retire.



The Social Security system is in deep trouble. A 1997 article in Financial Planning magazine pointed out that many corporations are warning employees not to count on Social Security. Henry Montgomery, a Minneapolis-based financial planner, advises clients to start viewing Social Security as a subsidy for lower- income individuals rather than a benefit that we will all collect. "You may get something, but you probably won't get it until age 70, and it won't be worth what you think it will be worth," Montgomery says.

    Social Security income has never been adequate to provide for a comfortable retirement. But for many of today's retirees, it provides a comfortable base. Even that is changing. And it will change rapidly as the baby boomers begin to retire around the year 2010. If the system were to continue as it is today, it is expected to start paying out more each year in benefits than it collects in taxes after 2012.

    Changing demographics are straining the system. When the first Social Security checks were mailed out in 1937, more than 40 workers were paying withholding taxes to support each retiree. In 1950, it was 16 workers to one retiree. Today just three workers support each retiree. And that will drop to two workers per retiree by the year 2030.

    Americans are living much longer, too. When the system was set up in the '30s, few people lived long enough to collect Social Security. Those who retire today may have 20 to 30 years ahead of them. That means that retirees are collecting much more than they paid into the system, putting more of a burden on working people.

    Some patches have already been applied. For instance, normal retirement age will increase gradually to age 67—and then perhaps beyond. Higher- income retirees pay tax on benefits, another trend that is certain to accelerate. So it is clear that middle and upper income taxpayers at the beginning of the 21 st century will get a haircut on their Social Security benefits.

    But the government's largest and most popular program is unlikely to disappear. Neither political party is eager to accept the blame for cutting benefits and/or increasing taxes. That became clear when a presidential advisory panel, after debating the problem for two years, reported in early 1997 that action must be taken "as early as possible" to save the system. Everybody read the report and commented on it. But nobody wanted to administer the harsh medicine.

    Still, it's worth looking at the conclusions drawn by this group because they sketch in broad outline possible changes to the system. The panel came up with three distinct solutions to bail out Social Security. The only area of agreement was that each group believed that some of the system's funds must be invested in the stock market to provide higher returns. (M1 the money is now invested in U.S. government bonds.)

    The first group, supported by the panel's labor representatives, wants to maintain existing benefits by increasing payroll taxes by 1.6 percent and reducing benefits slightly in the future. The second group would provide for a tax increase that would go into private retirement accounts. It would also increase the retirement age and reduce benefits for middle- and upper-income recipients.

    The third group would move toward "privatizing" Social Security by diverting a portion of the payroll tax into mandatory personal retirement accounts. This solution would preserve benefits for those 55 and older. It would also lift the retirement age, increase the taxes, and provide a floor benefit from the current system while depending more on the private retirement accounts.



Don't despair over Social Security. A 1996 study by the Employee Benefits Research Institute in Washington, D.C., found that 79 percent of workers did not believe Social Security will continue to provide the benefits it does today. And 23 percent did not expect to receive any benefits at all. But don't get bogged down in all the brouhaha over the shortfall in the system. You will get something from Social Security. It's just not clear yet what it will be. "The idea that Social Security is not going to be here is absolute foolishness," Minneapolis financial planner Henry Montgomery tells clients. "But when you look ahead 15 years, the benefits it will pay become imponderable."

    Even if benefits do shrink before you retire—or especially if they shrink—you want to be certain that you get what you've earned from the system. To do that, it's important to check regularly on your earnings and expected benefits. You should make a note to do so every three years.

    Social Security benefits are based on your lifetime earnings. If your earnings are reported inaccurately to Social Security or if the Social Security Administration records them inaccurately, it could affect your benefits. The Social Security Administration is not required to correct any error in an earnings statement that is more than three years old. That puts the burden on you to make certain your records are accurate and up to date. It is particularly important to check your earnings report if you change your name or if you marry and report your earnings on a joint return when you did not do so before. The Social Security Administration has also been known to lose earnings figures for women who marry and keep their maiden names.

    To check your earnings and benefits, call Social Security at 800-772-1213 and follow the automated instructions to request a copy of form SSA-7004. It should arrive within two or three weeks. When you receive the form, fill it out and send it back in.

    Within a month, you should receive your report. On the first page, you will see a message from the Commissioner of Social Security. The message being mailed out in 1997 assures us that "the Social Security Board of Trustees projects that the system has enough money to pay full benefits for the next 32 years. This means there is time for the Congress to make changes to safeguard the program's financial future."

    At the bottom of the page are the facts you provided on the form, including name, Social Security number, date of birth, recent earnings, and the age you plan to stop working. On the second page is a report of your earnings and estimated taxes paid. Check to make certain that you were credited for all your earnings. You are required to pay tax up to the Social Security wage base, which is $65,400 for 1997. So if you earn $100,000, your earnings will be recorded as $65,400. However, there is no limit on earnings taxed for Medicare, so you should see your full earnings reported for each year since 1992 under the Medicare column.

    On the next page you will see estimated monthly benefits if you retire at age 62, at full-retirement age—which might be 65, 66, or 67, depending on when you were born—and at age 70. The benefits at age 70 reflect credits for working longer. There are also some details about disability benefits. If there is a mistake in your record, call 800-537-7005 to request a correction. Then go through the process again in one year to make certain it has been corrected.



No matter what your age, your income, or your goals, taxes will figure somehow in your investment choices. What you pay in taxes has a great deal to do with how much money is left for you to spend. Obviously, the less tax you pay, the more you have.

    Unfortunately for those who would like to do some tax planning, the Tax Reform Act of 1986 made sweeping changes in the way Americans pay taxes, eliminating most tax shelters and writeoffs in exchange for lower rates. Starting in 1987, top individual rates were reduced from myriad rates ranging up to 70 percent to just two: 15 percent and 28 percent. Since then, of course, rates have been creeping up again, so that the top rate in 1997 is 39.6 percent. But the difference today is that there are few tax shelters available to shield money from that stiff tax rate.

    The Taxpayer Relief Act of 1997 provided a bit of help with the new Roth IRA, the college IRA, breaks on capital gains taxes, and tax-free gains for many homeowners who sell and make a profit. Still, one of the best of the tax shelters that we have today is the 401(k) plan. Tax Reform '86 had something to say about 401(k) plans, too. It reduced the maximum an individual could contribute in a single year from $30,000 to $7,000, a number that is indexed with inflation and that rose to $10,000 for 1998. It also imposed a stiff penalty of 10 percent on money that is withdrawn from 401(k) plans before age 59 1/2.

    But even with those changes, a 401(k) plan is a powerhouse—so much so that you should probe into a plan's provisions when you are job hunting. It will not be the deciding factor in a career move. But it could be a tie breaker.

    A word here about tax definitions:

* Tax advantaged is a catchall term that can be used to describe practically any kind of investment. It means nothing specific.

* Tax deferred means that current taxes are not due on an investment. The money in annuities and cash value life insurance policies enjoys tax deferral on investment earnings. Taxes are not due until the money is withdrawn.

* Tax free means that no taxes are due ever on an investment. That is the case for some types of bonds issued by federal and state governments. Municipal bonds, which are issued by state, city, or other local governments to pay for projects, are free of federal taxes. Sometimes called "munis," many are also free of state and local taxes.

* Pretax means that you may use money for some purpose before you pay tax on it. Sometimes you never pay tax on it. That's the case with money you are permitted to spend for certain health care or dependent care needs.

    When you contribute to a 401(k) plan, you use pretax dollars. The money is subtracted from the compensation on which you pay tax that year. So if you earn $65,000 and you put $5,000 into a 401(k) plan, your income will be reported as $60,000. Every state except Pennsylvania also permits you to subtract the 401(k) contribution from your compensation for state tax purposes.

    Suppose your combined federal and state tax bracket is 35 percent. If you took your $5,000 as taxable income, you would pay $1,750 in federal and state taxes and receive just $3,250 to spend. When you contribute to the 401(k) plan, you're getting the full $5,000 in your account. Your 401(k) plan also gives you continued tax deferral—or postponement of taxes—on both the money you contribute and the investment earnings on that money until you withdraw your money from the plan.


What People are Saying About This

From the Publisher
"A wonderful primer that guides even novice investors toward becoming more confident 401(k) investors. Everyone with access to a 401(k) account should read this book."
Don Phillips, President, Morningstar Mutual Funds

"If you are ready to take control of your financial destiny, you would be well advised to read this book."
Laura Tarbox, CFP, Tarbox Equity

Meet the Author

Rowland is a contributing editor to Bloomberg Personal Finance and is one of the most respected authors in the field of personal finance.

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