Inertia and My 401k

in·er·tia [in-ur-shuh, ih-nur-] –noun

1. inertness, esp. with regard to effort, motion, action, and the like; inactivity; sluggishness.
2. Physics. the property of matter by which it retains its state of rest or its velocity along a straight line so long as it is not acted upon by an external force.
3. Medicine/Medical. lack of activity, esp. as applied to a uterus during childbirth when its contractions have decreased or stopped.

As 401k participants everywhere ponder "What should I do with my 401k in this current market" they may want to give some thought to the beneficial aspects of inertia.

Synonymous with "inactivity" and "sluggishness", inertia is typically viewed as a negative characteristic in the 401k world. Indeed, the push by government and the 401k industry to make 401k's a truly workable retirement solution has centered on introducing policies specifically designed to counter what we can call "bad" inertia. Examples:

Examples of "Bad" 401k Inertia
Inertia causes workers to fail to enroll in 401k plans, often missing out on company match	Response: automatic enrollment
Inertia keeps workers from increasing contributions as wages rise	Response: automatic contribution arrangement
Inertia at the root of workers opting for low-yield investment options such as money market accounts	Response: automatically place 401k participants in qualified default investment alternatives

But there apparently is a bright side to 401k inertia as well. Some commentators credit employee inaction in the face of the historic market collapse of 2008-09 as the primary reason behind the remarkable recovery of 401k account balances that has occurred in the past year. Relatively few 401k participants reacted to the market turmoil by reducing their 401k contributions or moving account balances from riskier asset classes that were hardest hit into "safer" investments. Doing so, of course, would have been the classic panicked behavior expected of amateur investors: selling at exactly the wrong time.

For whatever reasons, workers by and large stood pat with their 401k's and were rewarded nicely. By the end of 2009, just 9 months after the market bottomed (DJIA @ 6,443 in March 2009) Fidelity and Vanguard both were reporting that most 401k participants had account balances higher than they did at the market's peak in October 2007.

"I think the good news is inertia took over and most people did nothing. During the rebound from April (2009) on, the inertia value of the 401k is very good."
- Jane Bryant Quinn as quoted in Employee Benefit News (4/1/2010)

"What to do with my 401k in this current market?" Consider setting a long-term course with regular 401k contributions, a solid 401k investment portfolio strategy and letting inertia take over from there.

Auto Annuity?

A few years ago government 401k regulations were modified to permit and encourage automatic enrollment of employees into 401k retirement plans. An employer that sponsors a 401k and that chooses to use automatic enrollment enrolls its employees in the plan automatically, by salary reduction, without requiring them to take any initiative or action in order to participate. Employees have to formally elect not to participate if they don't want to be in the 401k.

Automatic enrollment generally is considered to be a successful tactic for countering employee inertia. Many employees - especially younger and low-moderate income workers - who in the past tended not to bother signing up are now being enrolled in the company 401k plan by default.

Now government agencies now are testing the waters to see if the inclusion by default concept should be considered for employees starting their retirement. The concern here is that, having accumulated a 401k nest egg during their working years, new retirees often tend to withdraw their 401k assets in a lump sum and may not fully understand the importance of making the money last throughout retirement.

In response, policymakers are seeking input on the notion of "automatically annuitizing" 401k balances at retirement to provide a lifetime income stream. Under this concept, all or part of a workers 401k balance at retirement could be turned into an annuity that pays a monthly benefit for life.

A recent request for information (RFI) put out by the Department of Labor seeks input from the public and industry experts on numerous questions about 401k "lifetime income options". Several of the questions included in the RFI reveal there is a significant interest in the auto-annuity idea:

"11. Various "behavioral" strategies for encouraging greater use of lifetime income have been implemented or suggested based on evidence or assumptions concerning common participant behavior patterns and motivations. These strategies have included the use of default or automatic arrangements (similar to automatic enrollment in 401(k) plans) and a focus on other ways in which choices are structured or presented to participants, including efforts to mitigate "all or nothing" choices by offering lifetime income on a partial, gradual, or trial basis and exploring different ways to explain its advantages and disadvantages. To what extent are these or other behavioral strategies being used or viewed as promising means of encouraging more lifetime income? Can or should the 401(k) rules, other plan qualification rules, or ERISA rules be modified, or their application clarified, to facilitate the use of behavioral strategies in this context?

12. How should participants determine what portion (if any) of their account balance to annuitize? Should that portion be based on basic or necessary expenses in retirement?

13. Should some form of lifetime income distribution option be required for defined contribution plans (in addition to money purchase pension plans)? If so, should that option be the default distribution option, and should it apply to the entire account balance? To what extent would such a requirement encourage or discourage plan sponsorship?"¹

Clearly, government policymakers recognize that the move away from traditional defined benefit (DB) pensions that provide monthly pension benefits for life is permanent and won't be reversed. Their challenge now is to find ways to tweak and strengthen the 401k system so that it becomes a viable means of providing long-term retirement security to American workers.

There are numerous practical challenges in the way of auto-annuitizing including the big problem of inadequate average 401k account balances. Still, the concept seems to be gaining momentum and is likely to be seriously considered and debated in the coming months.

The complete lifetime income options RFI can be found on the Department of Labor's website. The questions asked in the RFI provide insights into the direction that 401k planning policy may be headed in the Obama administration. You can also publicly comment on the RFI at Regulations.gov. ²

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Notes:

1. US Department of Labor Request for Information Regarding Lifetime Income Options for Participants and Beneficiaries in Retirement Plans - 2/2/2010 [↩]
2. Search for "RIN 1210-AB33" to bring up current comments on the proposal as well as links to submit your comments. [↩]

New 401k Features to Watch For

401k's have taken a lot of heat recently. The 2008 market meltdown spoiled retirement plans for millions of baby-boomers nearing retirement. Not only did 401k market values tumble an estimated $2 trillion, but scores of companies stopped matching employee contributions altogether. Time Magazine's October 8, 2009 cover story even declared that it was "time to retire the 401(k)".

But rumors of the 401k's demise are premature. Despite many shortcomings, 401k's will almost certainly remain the primary retirement program for US workers for decades to come. Cost-conscious companies are not about to get back into the defined benefit pension business. The federal government is in no position to take on retirement funding responsibilities beyond social security and medicare. And state and local governments, buckling under the weight of their own overly-rich DB pensions, may be the next big growth area for 401k-type retirement programs.

So if 401k's aren't going away, it makes sense to see what the next generation of 401k's might look like. Here's a brief look at some new 401k features to watch out for:

1. Auto-401k - Continued emphasis on automatically enrolling employees in company 401k's and automatically defaulting employees into pre-selected investment funds. This movement is well underway and is strongly endorsed in federal legislation and supported by powerful interests like AARP. More focus will be placed on auto-enrolling all employees, not just new hires.
2. Auto-Contribution Escalation - More 401k programs will automatically step-up employee 401k contribution rates (e.g. 1% per year) until maximum threshold (e.g. 10% of pay) is reached. As with auto-enrollment, increases would occur by default and need to be specifically overridden by the employee.
3. Investment Options - Look for: 1) movement away from actively managed funds to lower-cost index funds, 2) greater use of "managed accounts" where an investment adviser places participants into a pre-mixed portfolio of funds based on factors like age, expected date of retirement, and risk tolerance, 3) more focus on maintaining low investment management and transaction fees and, 4) automatic re-balancing of investment portfolios.
4. Personalized Financial Advice - Online tools as well as face-to-face financial advice will cover broader spectrum of personal finance issues not limited to 401k investments.
5. Reporting & Disclosure - Pending legislation would require plan sponsors to provide clear and understandable fee disclosures on 401k investment options. Another recent piece of legislation would require sponsors to inform participating workers of the projected monthly income they could expect at retirement based on their current 401k account balance. The buzzword these days is transparency and 401k's will include more reporting and disclosure to try and ensure that participants are fully informed about their retirement program.
6. More and Better Annuities - Unlike traditional pensions that pay a monthly benefit for life, 401k's benefits last only until the account balance is depleted. Indeed, one of the shortcomings of 401k's is that far too many participants take money out in a lump sum instead of planning for a steady benefit distribution. Look for a variety of annuity-based 401k withdrawal options in the future.
7. Retention of Participants Post-Retirement - Upon reaching retirement age, the norm has been for participants to take a lump-sum withdrawal from their 401k and roll it over to an IRA. Plan sponsors are realizing that this detracts from the plans asset base, increasing fees and lowering buying power. Participants are realizing IRA investments have higher fees and lack the fiduciary oversight and advice tools available in an employer's 401k. Look for greater emphasis on retaining 401k participants into retirement.

Mistakes that Can Derail 401k Planning

Personal responsibility is a hallmark of 401k planning. So are personal mistakes. We all know that a market crash, job loss and other outside factors can wreak havoc on a 401k. But equally damaging are personal behavior obstacles that can get in the way of executing a retirement plan. These are behaviors totally within your control - if effectively recognized and dealt with. Here are some examples:

1. Procrastination and Inertia - It is human nature to put off doing things we don't like, things we don't feel comfortable doing or things we don't fully understand. But in the world of 401k's time really is money and procrastinating on actions like enrolling in your 401k, bumping up contributions, or reviewing and adjusting your investment mix can be costly indeed. Remedy: Just Do It! The cost of inaction is too severe as the following example shows:

	Mike	Bob
Starting Age	27	30
Annual Amount	$2,000	$2,000
Annual Return	8%	8%
Retirement Nestegg @65	$477,882	$374,204

.

Mike and Bob following the same retirement investment program with the only difference being that Mike got a 3-year head start. End result: The additional $6,000 dollars that Mike saved in the first three years becomes a $103,678 retirement savings advantage at age 65.

2. Information Overload - A big reason people procrastinate is that they feel overwhelmed with too much data and too many choices. This is especially true in the realm of investing. Some 401k plans offer participants dozens of investment funds to choose from. Result? Studies show that the more investment options offered, the more likely participants are 1) not to participate in the 401k and, 2) opt for "safe" bond or money-market funds if they do participate. Remedy: Keep things simple and stick with low-cost index mutual funds that mimic overall market performance. Research consistently shows indexing to be the best long-term 401k investment portfolio strategy.
3. Too Much Focus on the Short-Term - Too often 401k participants "buy high" and "sell low". When markets tumble and things are at their gloomiest, individuals have had enough and opt to get out. Conversely, they often jump in when markets are riding high and news is favorable. (One study by Hewitt Associates showed that, in 2008, 9 of the 10 most active trading days for 401k participants occurred the day after a large market downturn.) Remedy: Again, keep things simple and understand that attempts to time the market almost always fail. Stick with a consistent "dollar-cost averaging" approach. This allows more shares to be purchased when prices are low and fewer shares to be purchased when prices are high. The overall result is a lower average cost per share.
4. Too Much Focus on Lump Sums - The single greatest risk that people face in retirement is longevity risk - i.e. outliving one's assets. A study by McKinsey & Company projects that 1 in 5 retirees will live at least until 90, but run out of money at age 85. Yet the overwhelming majority of 401k participants opt to withdraw assets on their own schedule (often in a single lump sum), and only rarely convert them to a guaranteed lifetime annuity. One study found 3 out of 5 people were willing to exchange part of the guaranteed Social Security annuity for an immediate lump-sum of approximately equal actuarial value. Remedy: Do not let the general preference for lump sums over annuitized distributions drive your decisions. Take time to study the annuity option. Securing a guaranteed income stream for life may be you best defense against longevity risk.

Index Funds = Best 401k Investment Portfolio Strategy

You get what you pay for is one of those age-old cliches that has a lot of wisdom for daily living built into it. Generally, it's a good principle to bear in mind when paying for goods or services - except, that is, when it comes to investment management services!

A new study by a couple of high-powered finance professors comes down squarely on the side of low-cost index funds as the best 401k investment portfolio strategy. Running thousands of simulations using actual returns (1984-2006) on more than 3,000 actively-managed mutual funds, the authors find that active "fund managers do not have enough skill to produce risk-adjusted expected returns that cover their costs."

In other words, choose to pay high fees to get professional active investment management services and you are almost certain to end up worse off than if you had invested in passively-managed low-cost index funds. ¹

High investment management fees are one of the more insidious threats that 401k investors face. The following graph shows how a 1% higher fee can erode the value of a 401k account:

Unfortunately, tons of money are thrown into marketing actively-managed funds to 401k investors. In many cases, 401k participants are not sophisticated investors and follow the marketer's pitch. It is incumbent upon 401k account holders to ask questions about fees and performance. For most 401k investors, the guiding principle should be "you don't always get what you pay for - stick with low cost index funds."

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Notes:

1. An index fund is constructed to match the components of a market index like the S&P 500 or Wilshire 5000. Because index funds do not rely on professional managers to "pick" investments, fund expenses are kept low. [↩]

Cuts in 401k Matches are Being Reinstated

Employer matching funds have been the target of corporate cost-cutting for more than a year now. Looking to preserve cash and slash personnel costs hundreds of companies - big and small - have reduced or suspended their 401k matches. In recession, the allure to cut 401k matches is strong: 401k cuts typically equate to 2 percent or 3 percent of payroll and can be swiftly implemented.

But as the recession eases, there are strong indications of a slowdown in 401k cuts. The Pension Rights Center maintains an unofficial list of employers that have changed or suspended 401k matches. A plot of the announcements listed on their website shows a sharp fall off from levels of early 2009.

In the same vein, two recent studies (By Fidelity and Watson Wyatt) note that many companies that reduced or suspended matches now indicate they plan to reinstate them in coming months:

According to Fidelity:

Fidelity also said companies which lowered or suspended their 401(k) match in the past year are starting to reinstate the match.

The company said a survey of plan sponsors shows 27 percent of employers said they had already reinstated the match or plan to reinstate it within the next 12 months. The trend is particularly true with larger plans of 5,000 participants or more, with 44 percent of those employers indicating they have either already reinstated or plan to reinstate their match over the next year.
According to Wyatt:

In the next six months, 35% of firms that snipped away at their matching programs are planning to bulk them up again, according to a recent Watson Wyatt survey. That’s up from 24% two months ago.

The return of the 401k match is, of course, great news. Matches are easily the best incentive for employees to make (or increase) their own contributions. When employers cut matches, worker contributions invariably fall off. Hopefully, the damage done by the recent round of 401k cuts can be quickly undone.

Factors That Impact Optimal Retirement Replacement Ratios

A new study from the Michigan Retirement Research Center (MRRC) sheds more light on the topic of retirement replacement ratios - i.e., the percentage of pre-retirement income that needs to be targeted to maintain living standards in retirement. This is key component of effective retirement budget planning.

Typical advice suggests that replacement rates should be 70 to 85 percent of pre-retirement income. Target replacement rates are thought to be less than 100 percent for three main reasons. First, upon retirement, households typically face lower taxes than they face during their working years, if for no other reason than Social Security is more lightly taxed than wages and salaries. Second, households typically save less in retirement than they do during their working years, so saving is a smaller claim on available income. Third, work-related expenses generally fall in retirement.

Interestingly, the MRRC study finds that 75% is the median optimal replacement rate for married couples - seemingly confirming the standard rules of thumb often used in retrement budget planning. However, the study cautions that, as is often the case, the median misrepresents the wide variation in optimal replacement ratios for households in differing situations. For instance:

1. Replacement rates for a married couple need to be higher than for an otherwise identical single person, both because of couples’ greater expected medical expenses in retirement and because of longer expected longevity for at least one partner. While the study found the median optimal rate for married couples to be 75%, the median optimal rate for singles was 55%.
2. Replacement rates of low-income individuals and families would need to be higher than replacement rates for high-income individuals and families, because the reduction (relative to their levels during the working year) in saving and taxes in retirement would be smaller for low income individuals and families.
3. High-income households need lower replacement rates than low-income households, because of their substantial reduction in average effective tax rates. Of course, the opposite point applies going forward: if one expects future taxes to rise, optimal target replacement rates for highincome households should reflect those expectations.
4. Other things being equal, a household with lots of children will have a smaller replacement rate than a household with no children, because the couple with kids, once retired, will face far lower child-rearing costs than they did while working.



5. Other factors (including medical costs, educational attainment, and taxes) affect optimal retirment replacement rates.

The study concludes that no single target replacement rate is appropriate for all households and that financial planning tools (like online calculators) relying on simplified, rule-of-thumb replacecement ratios need to be used with caution. This research includes findings that will be incorporated into the next generation of 401k planning and online tools.

Still, there is something to be said for retaining the understandable and teachable concept of a 75% retirement replacement ratio. The number of people who do even basic retirement planning (such as using an online retirement calculator)is far too small. Overcomplicating the retirement planning discussion runs the risk of keeping even more people away from serious planning efforts.

Common 401k Planning Mistakes and Tips to Avoid Them

401k planning is a DIY (do-it-yourself) project. The IRS does their part to make it a challenging project by inserting plenty of complex rules, deadlines, and tax consequences that can trip up even the most experienced 401k planners. Here's a quick guide to the most common 401k planning mistakes and some 401k tips and tools to help navigate your way around them.

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Mistake 1 - Choosing to not participate
There's plenty of evidence that shows that when workers are left to initiate their own 401k plan participation, many just don't bother. Automatic 401k enrollment has become more common in recent years and has improved 401k participation rates. Still, millions who are eligible to participate in 401k's aren't doing so. Sometimes, non-participation may be sensible (e.g if the money instead goes to payoff high interest rate credit card debt), but for most workers, choosing not to participate in their 401k is a shortsighted move.
 
Remember that time is your best ally in accumulating a retirement nestegg. Younger workers, particularly, stand a good chance of accumulating substantial retirement accounts if they participate fully in their company's 401k. But data show these workers have the poorest participation rate:

Only 70%of workers under age 35 whose employers sposored DC plans participated in those plans in 2007. In contrast, the take-up rate among workers aged 35-44 was 82%, and the take-up rate among workers aged 45 to 54 was 83%.¹

Here are a few good reasons to participate:

1. Tax Benefits - the money you contribute is tax-deferred - from federal and state income taxes. If your marginal tax rate is 25%, this means you can add $100 to your 401k, by reducing your takehome pay only $75. Investment earnings in your 401k account are also tax-deffered.
2. Employer Match - Many employers match your contributions up to some limit. This is free money. With a 50% match (using the above example) you could get $150 added to your 401k, by reducing takehome pay only $75.
3. Autopilot Savings - 401k contributions are taken from your paycheck before you get your hands on it. By diverting even a modest sum on a regular basis, you can build substantial wealth over the long term. Moreover, you will develop a regular savings habit and benefit from the dollar cost averaging² investment strategy.

Bottomline: If you elect not to participate in your company's 401k, you substantially lessen the odds of having a decent retirement. Social security won't be enough to provide a comfortable living standard and few jobs have traditional defined benefit pensions anymore. The 401k is your best retirement savings option in today's world.

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Mistake 2 - Not taking full advantage of the employer match
One of the worst mistakes 401k participants can make is not taking full advantage of employer matching dollars. Employer matches typically are capped at a percentage of pay. For example, a company may offer a dollar-for-dollar match up to 3% of pay, or, a 50% match up to 6% of pay. Whatever the employer match, it is free money and critically important to accumulating an adequate retirement nestegg. Review your employer's 401k match policy carefully and be sure your contributions are set to get every possible matching dollar.

Use this 401k calculator to see just how important employer matching funds can be to achieving your retirement goals.

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Mistake 3 - Withdrawing funds too soon
In general, 401k funds are meant to be tapped after the participant reaches age 59-1/2. There are a couple of ways you can take out funds earlier without penalty, but the rules are complex and need to be carefully followed.

1. Strategy 1: 55 and Out - If you are at least 55 when you leave your job, you can take penalty-free distributions from your 401k (you still pay income taxes on withdrawals). If you use this strategy you'll want to be careful not to rollover 401k balances to an IRA. If you transfer to an IRA you lose this option.
2. Strategy 2: Substantially Equal Periodic Payments - Regardless of age, you can withdraw 401k funds penalty free after leaving employment under section 72t of the tax code. This strategy requires that distributions be made based on expected life expectancy for at least five years or until the participant reaches age 59-1/2, whichever is longer. There are three ways to compute 72t distributions. Use this 72t calculator to determine your allowable 72(t)/(q) Distribution.

IRS rules regarding 72(t)/(q) and "55 and out" distributions are complex. Remember too that taking early distributions leaves less for your retirement years. Early 401k distributions should only be done after careful planing and deliberation; always consult a qualified professional before initiating an early distribution.

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Mistake 4 - Borrowing from your 401k
Even if your employer permits you to borrow from your 401k (85% of sponsors do), make every effort to avoid doing so. 401k loans usually don't make financial sense for the following reasons:

1. you're not borrowing anything - you're simply spending your own money
2. you're losing valuable investment earnings on the money you "borrow"
3. you're losing the benefit of compounding while you have the loan outstanding
4. you're paying interest on the 401k loan with after tax dollars, thereby losing the 401k tax advantage
5. you'll pay taxes a second time when you eventually withdraw the money in retirement
6. interest on the loan is not tax-deductible, even if funds are used for a home purchase

It is generally preferable to use savings or to borrow in some other way (e.g. home equity or consumer loan). A 401k loan could harm your retirement plans. Use this 401k loan calculator to see how taking a 401k loan will impact your long-term retirement stategy.

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Mistake 5 - Mishandling a 401k loan
In some cases, taking funds out of a 401k is the only option available. If you are in this situation and need to choose between borrowing from your 401k or taking a 401k "hardship withdrawal", the loan is usually the preferred route. This is because hardship withdrawals trigger a 10% early distribution penalty if you are under age 59-1/2.

In this case, it is critical to be aware of these common 401k loan pitfalls:

1. if for any reason you fail to repay the loan, it will be considered a premature distribution, subject to taxes and the 10% penalty noted above
2. if you quit or lose your job, you will have to pay the loan off in full, typically, within 60 days. If you can't afford to pay the loan off, it will be considered in default and you will be taxed on the outstanding amount, plus incur a 10% early withdrawal penalty.

Taking out a 401k loan is seldom a wise financial move. But if you do take a 401k loan (and 20-25% of eligible participants do take one), be sure not to make the situation even worse.

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Mistake 6 - Botching a rollover
When you separate from your employer, you may choose to rollover account balances to an IRA or to your new employer's 401k. There are many good reasons to consider doing a rollover. But, be careful to direct that the rollover be made directly to the new retirement account's custodian. The IRS permits rollover checks to be made out to you personally, but choosing this method can cost you dearly:

1. If the rollover check goes to you, your old employer will be required to withhold 20% of the amount for potential taxes. Within 60 days, you will have to payover 100% of the account balance into your new retirement accout, meaning you'll need make up the missing 20% out of your pocket. You can recoup this 20% when you file your annual tax return, but in the meantime you've needlessly tied up your money.
2. If you have trouble coming up with the full amount, or simply forget to pay the money into your new account within 60 days, the situation gets much worse. The IRS will consider the entire balance a taxable distribution subject to income tax and, perhaps, the dreaded 10% early distribution penalty.

Bottomline: Keep things simple and always do direct custodian-to-custodian rollovers.

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Mistake 7 - Knowing when not to rollover
A 401k rollover can sometimes cost you in other ways. We noted above that if you leave employment at 55 you could lose the option to take "55 and out" distributions if funds are rolled into an IRA. Similarly, if your 401k includes company stock that has appreciated in value, you may be better off using the "net unrealized appreciation" IRS rule to save on taxes.

Heres how you can use net unrealized appreciation to your benefit:

when you retire or leave employment, take a lump-sum distribution of the entrie 401k account balance

only rollover the portion of the balance that isn't company stock

transfer the company stock to a taxable brokerage account

You'll have to pay taxes on the company stock you didn't rollover, but the tax will be based on the share prices you originally paid, not current market prices. Also, as you sell shares in the future, taxes will be capped at the top 15% long-term capital gains rate. For many people, this will be much more favorable than their regular marginal tax rate.

Finally, keep in mind that rollover to an IRA may also cost more in plan service fees since you lose the employer's bulk buying power.

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Mistake 8 - Waiting too long to withdraw money
Because the IRS defers taxes on 401k contributions and earnings to facilitate your retirement, they want to be sure get their share when you do retire. For this reason, there are "required minimimum distribtion" rules that madate 401k funds start being withdrawn starting the year you turn age 70-1/2.

If you fail to withdraw your RMD by the applicable deadline, you will owe the IRS a penalty of 50% of the shortfall. This is referred to as an "excess-accumulation penalty" and is one of the most onerous penalties in the IRS code.

This 401k RMD calculator can help you determine the amount and timing of your 401k required minimum distribution.

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This article is one of several informative posts in the latest Carnival of Personal Finance at Fire Finance.

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Notes:

1. Congressional Research Service, Retirement Savings and Household Wealth in 2007 [↩]
2. Dollar cost averaging is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. Eventually, the average cost per share of the security will become smaller and smaller. Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time. [↩]

2009 401k Maximum Contribution

This is the maximum amount you are allowed to contribute to your Individual 401(k) account per year as set by the federal government. In 2009, the maximum contribution to an Individual 401(k) is $49,000 (an increase of $2,000 over 2008) for individuals under 50, and $54,500 for those 50 and over. Self-employment income of $162,500 or more is required to qualify for the maximum contribution in 2009.

If you earn less than $162,500 in 2009, your maximum is calculated as follows: First, as the employee, you are able to contribute up to $16,500 in 2009 to your Individual 401(k) or 100% of your self-employment income, whichever is less. For individuals age 50 or over, an additional $5,500 catch-up contribution increases this portion of your contribution to $22,000, but still limited to no more than 100% of your earned income. Second, you are allowed employer contributions - even though self-employed people are fact their own employee. Employer contributions, for the self-employed, are limited to an additional 25% of adjusted net business profits, up to the maximum total amount allowed per year.

As an example, consider a 25-year-old self-employed person with an net income of $40,000 per year. They would be able to contribute:

• $16,500 as an employee contribution
• $7,434 as an employer contriubution (This is 25% of adjusted net income $29,739. Adjusted net income is calculated as net business income of $40,000 - deduction for Self-Employment Tax of $2,826 divided by 1.25.)
• $23,934 Maximum contribution for 2009

It is important to note that you may be subject to additional contribution limitations if you participate in an additional retirement program through another employer. For 2009, total retirement plan contributions are limited to $49,000 or 100% of your total compensation for the year ($54,500 if age 50 or older). This includes contributions to your Individual 401(k) as well as any other employer plan. It also includes profit matching and employer contributions. Contributions to a Traditional IRA or Roth IRA are not included in this limit. Catch-up contributions for individuals over 50 are also not included in this limit.

Bits of Advice About 401k Loans

The financial crisis has more people than ever looking for ways to get access to their 401k nest eggs. Most employees can access their 401(k)'s by taking a loan or a more difficult to get "hardship withdrawal". Almost 90% of 401(k) plans allow participants to take loans, and many do. But before turning your nest egg into scrambled eggs, you should consider the following bits of financial advice on 401k loans culled from some widely respected sources:

charles SCHWAB oninvesting (Fall 2009)

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Q Should I Borrow From My 401(k) Plan?

A In a word, no. Borrowing from your 401(k) plan isn't a good idea unless you have no other options. Here's why:

• Until you repay the loan, you'll have a smaller portfolio to take advantage of your 401(k)'s potential tax-protected growth, likely reducing its size at retirement.
• You must repay the loan in full, with interest, within five years. If you don't repay in that time, the loan is considered a distribution and you'll have to pay income tax on the outstanding balance - plus an early withdrawal penalty if you're under age 59-1/2.
• Similarly, the loan is considered a distribution if you leave your job for any reason and don't repay it in full within a set time-frame - typically 90 days.
• There isn't a fee for borrowing from a 401(k) plan, but it'll cost you more to repay the loan than it costs to contribute the money in the firsrt place: Loan repayments, unlike contributions, must be made with after-tax dollars.

msn money

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(L)et's go through the pros and cons of borrowing from your 401(k).

The pros:

1. There is no credit check. You don't have to apply for the loan, and you can make plans knowing that you will get the loan.
2. There is a low interest rate. You pay the rate set by the plan, usually a couple of percentage points above the prime rate.
3. It provides a great return. If your money market account is earning 3% and you pay yourself back at 6% or 7%, it looks like a good deal.
4. The interest is tax-sheltered. You don't have to pay taxes on the interest until retirement, when you take money out of the plan.
5. It's convenient. Some plans only require you to make a phone call, while others require a short loan form.

The cons:

1. About that credit check: Of course there isn't one. You're not borrowing anything. You're spending your own money.
2. You're losing interest. The net effect is that you have less money to invest and to earn interest. The money you borrow -- or take out -- of your retirement plan no longer appreciates in value from interest, dividends and/or capital gains in conjunction with the rest of your investment portfolio. Remember that you aren't really borrowing. All you are doing is using money from one account, such as your checking or savings account, to repay the money you borrowed from your 401(k). And when you take money out of that checking or savings account, that money loses interest, too.
3. It's not tax-sheltered money anymore. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all made back into the 401(k) with after-tax dollars. So, let's say your monthly interest payment is $300 and you're in the 28% tax bracket. You'll have to make $416 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again.
4. Unless you repay the loan, it is considered a premature distribution. You would owe federal and state income taxes as well as that 10% penalty if you are under age 59 1/2.
5. The loan isn't tax deductible. It's considered a consumer loan, so there is no tax advantage.
6. It affects your psychology toward retirement saving. If possible, your retirement money should sit untouched until you retire. It's too easy to get in the habit of dipping into your 401(k) instead of saving for things you need along the way. Keep your 401(k) in a loan free zone.

Kiplinger.com

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(W)orkers who are considering taking a 401(k) loan to be aware that should they default, 40% or more of the money could go to the government, assuming 25% in federal taxes and 5% in state taxes, plus the 10% early-withdrawal penalty. So you might net only $4,500 from a typical $7,500 loan.

ABC News

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(Here's) a list of four questions potential 401(k) borrowers might ask themselves before taking out a 401(k) loan through an employer:

1. If you did not borrow from your 401(k), would you borrow that money from some other source (e.g., credit card, auto loan, bank loan, home equity, etc.)?
2. Would the after-tax interest rate on the alternative (non-401(k)) loan exceed the rate of return you can reasonably expect on your 401(k) account over the loan period?
3. Would you be able to make your 401(k) loan payments without reducing your regular 401(k) contributions?
4. Are you comfortable with the requirement to repay any outstanding loan balance within 90 days of separating from your employer, or pay income tax and a 10 percent penalty on the outstanding loan?

A "yes" answer to each of the four questions could mean a 401(k) loan is a better option. A single "no" suggests other options should be considered.

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