401K

A 401K account is a retirement account set up through your employer. You determine the percentage of your paycheck that you want taken out of your paycheck and invested into the 401K. The advantage is that no income taxes are due on those funds until the time that you take them out of the 401K. Additionally, any interest earned on your investment is not taxed until you start liquidating the account. Finally, the tax rate that you will pay on the 401K is the rate that you pay the year that you take it out, not the year that you invested the funds. This is an important point as the most people anticipate that their tax rate will be less, post-retirement.

There are a couple of other points to consider. First, the money invested by the employee always belongs to the employee. Secondly, many employers, to encourage employee participation, will match a percentage of the amount contributed by the employee. For example, if the employee wishes to invest 4% of his or her income the employer could state that the employer will match 25% of the employee's contribution (or 1% of income in this example). Thus at the end of the year the employee received 1% more in tax free income than if he or she did not contribute to the company's 401K plan. Typically most companies will use what is called a vesting period. Let's assume that the employer states that the vesting period is 20% per year. That means that if the employee is in any way no longer employed by the company after 13 months, only 20% of the amount the company contributed goes to the employee, the balance goes back into the 401K account and is distributed pro-rata to the balance of the employees. Using the 20% per year example, after 5 years the employee can leave and take all of the funds that the company contributed. Employers use vesting as a retention tool. Finally, and this typically relates to small companies, there are federal laws in place that attempt to make sure that if there are a handful of employees that make disproportionately more income than the rest of the employees, the amount that these highly compensated individuals can contribute to the 401K program comes into line with the averages of all employees. This is another reason why business owners encourage high 401K contributions from all employees.

You can borrow from your 401K account for certain circumstances as defined by your company's 401K program and subject to IRS limitations. You should know that the maximum repayment term allowed by the IRS is 5 years. More importantly, if for any reason you cease employment at the company you MUST pay back the loan within 30 days or suffer a 10% penalty and taxes due on the amount of funds borrowed.

Your first place to stop in obtaining information about your company's 401K program is your Human Resources Department. Additionally as FMI College Planning Financial's client, we will review your company's 401K with you to explain it to you and assist you in determining how best to allocate your contributions and/or if contributing to the program is in your best interest.

It is important to realize that after you leave a company that has a 401K, your 401k investment becomes at the whim of the investment firm that is managing that account. Contact FMI College Planning Financial and we will walk you through our seven step process to make sure that your funds are still being wisely invested.