401(k) Plans and the 403(b)

A section 401(k) plan, commonly known simply as a 401(k), is a qualified profit sharing plan that gives an employee the option of putting money in the plan (up to $10,500 per year) or receiving taxable cash compensation.

You either can take the money home as additional pay, or have the funds deposited into a 401(k) plan for you. An employer usually adds a percentage of the employee's contribution to the employee's plan.

Both your money and your employer's contribution are made with pre-tax money. That means that the income you contribute to your 401(k) isn't considered taxable income at this time. It will, however, be taxable when it's withdrawn.

The 401(k) accounts were introduced in 1982, and became extremely popular in the ensuing years. In fact, employees sometimes get frustrated when their employer doesn't provide a 401(k).

If you have a different type of plan, however, don't assume that you're being cheated by not having a 401(k). Another type of plan is likely to do as well, or perhaps even better. They're certainly preferable to no employment plan, and, 401(k)s do have many advantages. They're not, however, the only game in town.

While many employers match (or partially match) 401(k) contributions by employees, it's not required. Some employers contribute nothing. Maybe the employer can't afford to contribute to the plan, and simply offer the 401(k) as a means for their employees to contribute to a retirement fund, or your employer offers the 401(k) plan as a supplement to an already existing retirement plan.

When an employer doesn't contribute, all the contributions to the 401(k) come from an employee. The employer would pay only to install and administer the plan.

If your employer does contribute, however, it's important for you to put enough money in your 401(k) plan to take advantage of the company match. If your company matches dollar for dollar up to 3 percent of your salary, for instance, then you should by all means contribute at least 3 percent. If the company puts in dollar for dollar all of your contribution up to 6 percent, make sure you're putting away 6 percent in your 401(k).

It's important that you have a good understanding of your 401(k) plan. You should be aware of when you're able to change the amount of your contribution and move your money from one investment to another.

Employees get to decide where to invest their 401(k) funds from a list of choices provided by the employer. A greater number of choices increases the cost of the plan, so most employers provide about six choices.

If you have a 401(k), you should try not to touch it until retirement. If you need to, however, if there is a “hardship,” there is a special provision that allows you to get your 401(k) money early.

Under the hardship provision, you can withdraw from the plan while you're still working for the firm that provides the plan. You don't need to quit to get your money out of the retirement plan. You just ask your employer for the money. Your employer must make sure that the reason you need the money falls within the IRS guidelines. If your need qualifies as a hardship, you'll get your money.

You don't need to repay the withdrawn funds, but you'll need to pay tax on them at the end of the year. Tax is withheld when you withdraw the funds.

Some “hardships,” as specified by the IRS, include the following:

• First-time homebuyer
• Medical bills
• Education costs

Some plans permit employees to borrow money from their 401(k)s. It's extra paperwork for the employer, so some do not provide this option. And, some employers feel strongly that 401(k) money is retirement money and shouldn't be borrowed against, so they decline to provide a loan provision.

If permitted under your plan, you can borrow up to 50 percent of the total value of the account, up to $50,000. The loan must be repaid within a five-year period, or it becomes a withdrawal.

Many employees love the loan provision because it allows them to pay themselves the interest on the loan instead of a bank or credit union. When you repay the loan (with interest) the interest is added to your account.

There are, however, some problems with borrowing from your 401(k). If you borrow money and then leave the company, the loan must be repaid within a very short period of time.

If you decide to borrow from your 401(k) to buy a car, for instance, and then you leave the company for a better job, you must either borrow from someplace else to repay the loan, or the loan becomes a distribution, which is a taxable event.

These retirement plans are designed for retirement, and there are penalties if you take the money out ahead of time. Money you withdraw from a 401(k) is taxed at your current income tax bracket. And if you are younger than 59 and a half when you withdraw funds, a 10 percent penalty is due on top of the income tax liability.

So if you borrow $8,000 for a car, leave the company, and can't pay your loan back within the required period, you'll pay income tax ($1,200 if you're in the 15 percent bracket), plus $800 penalty. Ouch!

A good reason to borrow from your 401(k) is to repay credit card debt. If you've racked up debt and you're paying 18 percent interest on your balances, you should consider borrowing from your 401(k) to pay off the cards. You'll pay a lot less interest every month on the money from your 401(k). Just make sure that you don't turn around and create new balances on the cards.

Another problem with borrowing from your 401(k) is that the loan is invested at a fixed rate as you repay it. It's similar to having your money invested in money market funds, and you'll realize a lower rate of return.

401(k) is an IRS code section that permits this type of retirement plan (a type of profit sharing plan). If you work for a nonprofit organization, such as a hospital, charitable organization, or university, you'll fall under the IRS code section known as 403(b). Look familiar? 403(b)s mirror 401(k)s, except for until recently, the investment vehicles could only be offered through an insurance company. Now, 403(b)s can be set up through mutual fund companies and you can roll a 403(b) into a 401(k) if you go from a nonprofit to a for profit company.

Excerpted from The Complete Idiot's Guide to Personal Finance in Your 40s and 50s © 2002 by Sarah Young Fisher and Susan Shelly. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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