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Understanding The Need For 401K Retirement Plans

Aug 17, 2007
If your company offers a 401K retirement plan, you have the option to select the funds you desire to invest. Your choice must be from a list of funds provided in the 401K plan. Each employee can contribute up to a certain percentage of their pay, which is deducted directly from the salary before taxes into a 401K. Some employers match a certain percentage of your contribution, which is then invested. These funds grow without being taxed. They can be withdrawn only when you reach the age of fifty-nine and a half. You must pay income tax at the time of withdrawal. The funds in the account can be invested in different stocks, bonds, mutual funds or other assets, and are not taxed on any capital gains, dividends or interest until their final withdrawal.

What is a 401K?
A 401K is an employer-sponsored retirement plan and is grouped into two categories.

1. Defined Benefit Plan: The employer promises to pay a defined amount to retirees who meet certain eligibility requirements. It usually links the benefit to the amount of service and final average salary. Employees can either receive it as monthly retirement income or as a lump sum on retirement.

2. Defined Contribution Plan: This is a contribution that an employer makes, and not the benefit that the employee will receive at retirement. Since it is not a monthly income, an employee receives the amount in a current, deferred lump sum, or annuity on leaving the company. Laws prohibit companies from utilizing the 401K money, but they can invest 401K money in stock funds. If the company goes bankrupt then you lose that money.

Benefits of 401K Plans

There are five key benefits.

1.Tax advantage

2.Employer match programs

3.Investment customization and flexibility

4.Portability

5.Loan and hardship withdrawals

How to Balance 401K Funds
Do not invest heavily in the stock of your company. Instead, diversify your investments. Contribute the maximum tax deferred amount to your 401K each year. You can also make additional, non tax-deferred contributions of less than $35,000 or 25 percent of your annual income. Your age and company's policy plan are the deciding factors in rebuilding your 401K balances. A younger person will have a longer time to rebuild, than a person who is over 50 years of age.

The suggested allocation for balancing 401K at the three life stages is:

1.Aggressive: For those with 35 or more years until retirement.

50%-large cap stocks

15%-mid cap stocks

15%-bonds

10%-small cap stocks

10%-international stocks

2.Moderate: For those with 20 years until retirement.

35%-large cap stocks

35%-bonds

10%-mid cap stocks

10%-small cap stocks

10%-international stocks

3.Conservative: For those within 10 years of retirement.

40%-bonds

30%-large cap stocks

10%-mid cap stocks

10%-international stocks

10%-cash

You can derive the maximum benefits from your 401K plan, if you make wise investment choices and build your portfolio carefully. 401K plans are the best way to plan for your retirement.
About the Author
David Gass is President of Business Credit Services, Inc. His company publishes a free weekly e-newsletter on Small Business Consulting at their web site http://www.smallbusinessconsulting.com
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