Max Out On Your 401 - k - retirement savings plans

Kiplinger's Personal Finance Magazine, May, 1999 by Mary Beth Franklin

HAVING THE BEST INTENTIONS IS GOOD, BUT MAKING THE MOST OF YOUR PLAN IS BETTER. MUCH BETTER. HERE'S HOW TO MAKE YOUR 401(K) A SUPERHIGHWAY TO RETIREMENT SECURITY.

Tired of hearing about the precarious future of social security and listening to the steady stream of rhetoric about potential solutions? Skeptical about President Clinton's plan for Universal Savings Accounts and Senator William Roth's proposal for yet another tax-favored retirement-savings plan: the Roth 401(k)? We don't blame you.

But while Washington talks (and talks) about the system's future, you can do something about your own. If you are one of the 30 million or so workers with a company-sponsored 401(k) plan, that's where you should start. If you work for a nonprofit organization, you may have a similar tax-deferred savings option called a 403(b) plan, and public employees often participate in a 457 plan--all unimaginatively named after sections of the federal tax code.

They all work about the same way: Defer part of your current income into a tax shelter, where the money can grow unmolested by the IRS until you withdraw it. Avoiding taxes when the money goes in means you have more money to save and you'll enjoy supercharged compounding along the way.

You don't have to be a Wall Street wizard to make a 401(k) work its magic, but you do need a plan: You can't leave something this important to happenstance or guesswork. On the following pages you'll find the tools you need to max out your own 401(k), and you'll meet fellow workers who are working wonders with their plans.

CONTRIBUTE EARLY AND OFTEN

As they say about voting in Chicago, early and often is the key to success. At 26, Bryan Lee of Cambridge, Mass., is well on his way to a secure retirement. Now a production planner and buyer at MicroTouch Systems Inc., in Methuen, Mass., Lee started to stash earnings from summer jobs into a retirement account at age 15 and has accumulated nearly $50,000.

Nothing drives home the powerful mixture of time and tax-free growth more than this fact: Even if Lee never saves another dime, his retirement account will hold nearly $3 million when he celebrates his 65th birthday, assuming it earns an average of 11% a year, about the average return on stocks over the past 75 years. If inflation averages 3% a year--again, about the average since the '20s-his stash will be worth almost $1 million in today's dollars.

But Lee has no intention of quitting. (He jokes that he has been "brainwashed" about the importance of saving for retirement by his mother, Dee Lee, a financial planner.) With no family obligations, mortgage or car loan to worry about, he'll keep contributing the maximum for as long as he can. As the box on page 69 shows, the law sets a $10,000 annual limit for 401(k) contributions; but your individual plan may set a percentage-of-pay restriction that results in a lower dollar cap.

For example, at MicroTouch Systems, which manufactures touch screens for ATMs and medical equipment, employee contributions are capped at 15% of pay. Lee's annual salary is $36,000, which means his personal limit is $5,400 a year. A company matching contribution--dollar for dollar for his first $600 and 50 cents on the dollar for the next $600--adds $900 a year to his account.

KNOW THE RULES

Knowing as much as you can about the plan you are in--or the plan of a company you may be considering--is crucial. Most large companies match a portion of their employees' contributions. The average match last year was 50 cents on the dollar for the first 6% of salary, according to the Spectrem Group, a research consulting firm in Windsor, Conn. Its most recent survey found that 82% of 401(k) participants enjoy matching contributions.

There is no rule of thumb for when the match is applied: It may be every pay period, every quarter or even on the last day of the year. Knowing when your company makes its matching contributions could be a factor if you are thinking about switching jobs. You don't want to leave just before the match is made. Investigate any new employer's plan by determining whether there is a company match and how soon you can contribute to the plan.

Lee stumbled on this point when he joined MicroTouch last year. He knew he would have to wait six months to join the 401(k), but he didn't realize that his six-month anniversary would come just after the once-a-quarter plan entry date. That meant a nine-month lockout, which prevented Lee from contributing about $4,000 that he would otherwise have stashed in the plan.

It may not sound like a big deal, but think how that $4,000 could have flourished in a tax shelter over 40 years. At 11% a year, those missed contributions would have grown to more than $250,000. "It was a real learning experience for me," says Lee. "If you are going to change jobs, consider the time of year when you make the switch and get a full offer--including an explanation of all the benefits--in writing before you make a commitment."

That's good advice, particularly for younger workers who will hold an average of seven jobs during their working years. Each new job could mean up to a year's delay in contributing to the new company's retirement plan--with devastating consequences over a lifetime (see the box on page 64 for a way around this problem).