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New rules for 401K plans
Most folk are familiar with what a 401K plan is, but I shall briefly explain for those who may not be too sure.
401K refers to the specific IRS code that covers private employer-based retirement plans. Those who worked in public jobs, as police, teachers, nurses, etc., are covered under similar plans under tax code 403B or 457 plans. All plans share some basic similarities but likewise have some differences.
The basic premise of a 401K plan is that it is an employer-sponsored retirement account. Employees generally can invest a sum, frequently up to 10 percent of their earnings on a pre-tax basis, and a portion may be matched by the employer either at 100 percent or a lesser amount. In many of the common formulas I have seen, the employee invests 6 percent and the employer matches that at 50 percent for a 3-percent contribution.
Anyway you look at it, that is free money and free money can’t be bad. If you put in 6 percent and the company matches, that 3 percent is an immediate 50-percent increase in your account.
If you are still working and have the ability to contribute to a 401K or similar public sector plan, I would strongly urge you to review your options.
When you have the funds deducted from your paycheck you can direct where those funds are invested. So a 401K plan is a self-directed retirement plan. You pay no taxes on your investment, the company’s contribution or the accumulated earnings until they are withdrawn.
Many people who work for a large public corporation have been heavily invested in their company stock. This is a very loyal thing to do, but not necessarily very wise.
Many people who worked for General Motors, Washington Mutual and Enron, just to name a few, found out the hard way that having a large portion of their retirement assets in any one company may not be the wisest decision they ever made.
Currently in the U.S. there are 72 million people with over $3 trillion invested in 401K accounts. That is approximately 1 in every 3 people with assets in such an account. That $3 trillion sounds like a huge amount of money but when I did the math it came out at just over $41,000 per account, hardly a king’s ransom, though many people do have multiple accounts.
These accounts became highly popular both with corporations as well as employees starting in the mid- 1980s. For the employer it allowed them to discontinue the defined benefit pension plans that were commonplace at that time.
In a defined benefit pension plan, the employer assumed all the investment risk, as the employee was guaranteed a set pension based upon a set formula. Under the 401K scenario, all the investment risk was placed directly onto the investment choices made by the employee.
The changes that are happening currently are in regard to the statements you receive from the plan. They have been simplified and a new section has been mandated that will show what fees and expenses are being deducted from your account.
These fees can have a sobering effect on your returns over a number of years. Full disclosure will be the new rule that all plans have to abide by and from my perspective it is about time.
Research shows that the larger the employer the lower the fees and that is simply due to the economies of scale. That is where set expenses are spread over a larger number of participants. Smaller employers are expected to have a higher expense basis.
Employers control the plans available to you, so if you are still working and you see your plan has a high expense ratio, you can ask your employer to shop around for a plan with lower costs.
However, if you already are retired, you can convert your 401K to an Individual Retirement Account (IRA) without any taxable consequence. This is done every day by thousands of people acting either on their own or with the assistance of an insurance agent or other investment professional.
In closing I would advise everyone who receives a new-looking statement from their 401K plan in the coming months to take a few minutes to review it closely and ask questions to make sure you understand what you are reading.
Remember, it is your money and the only silly question is the one that you didn’t ask. You need to be aware of what you have and what you are paying for someone else to manage your money. It is wise to shop around and make sure you fully understand and are comfortable with where and how your funds are invested.
Phil Castell owns Castell Insurance in Sequim. Reach him at 683-9284 or Phil@castellinsurance.com.