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401(k)s: 8 Key Tactics You Need to Know
to Get Full Benefit from Your 401(k)

About 47 million Americans are taking advantage of a 401(k) account through their employer, according to the Investment Company Institute, to the tune of over $2 trillion in assets. But to get the most "bang for your buck" -- whether you haven't yet invested or have been doing it for some time -- it helps to know a few key tactics, as well as a bit of background into why 401(k)s are so useful.

401k advice origin

Ever wonder how the 401(k) got its name? It's taken from the Internal Revenue Code that established them -- section 401(k).

Understanding 401(k) Basics

A 401(k) is a way to save and invest, through your employer, for retirement. Typically, an amount you designate will be automatically deducted from your paycheck and invested into one of the options your company offers (and which you choose).

The federal government developed the 401(k) in 1981 to encourage people to save for retirement. The "encouragement" comes in the form of tax advantages, as you don't have to pay income taxes on the money you contribute to a 401(k) until you withdraw it (at which time you'll probably be in a lower tax bracket).

How to Get the Most From Your 401(k) Contributions

  1. Make Regular Contributions. To benefit from a 401(k) you must participate in it. Contributing will reduce your taxable income and grow, tax-deferred, until you retire. Further, many employers will match your contributions, or a portion of them, and that "free" money is tax-free -- and an excellent way to boost your nest egg. Sign up for a certain amount to be automatically deducted from your paycheck and put into your 401(k), and you don't even have to think about it.

  2. Know What You're Entitled To. The law says that you can start contributing to a 401(k) after one year of working with your employer. Your company may offer it sooner than that, but they cannot legally keep you from contributing for longer than one year.

  3. Know the Limitations. The IRS sets a maximum pre-tax contribution limit. For 2006, the maximum you can contribute is $15,000. Next year and after, the limit will be increased in $500 increments to account for inflation. Some employers also place maximum limits on 401(k)s, so get to know your company's policy.

  4. Contribute as Much as You Can, but at Least Enough to Get Your Employer's Match. Ideally, you should contribute the maximum amount each year. However, if you can't invest that much, at least invest enough so that you are getting the maximum amount of your employer's match. Not doing so is like turning down free money.

    401k advice

    Maxing out your 401(k) contributions now will ensure you'll have a happy, relaxing and carefree retirement later.

  5. Consider Catch-Up Contributions, if You Qualify. For those who will turn 50 years or older during the calendar year, and have already maxed out their 401(k) contributions, catch-up contributions are an option. An additional $5,000 can be invested by those who qualify in 2006.

  6. Borrow from Your 401(k) Only as a Last Resort. If you take money out of your 401(k) for a loan, you will have to pay yourself back, plus interest. Further, if you don't pay the loan back within five years you'll owe a 10 percent penalty, and if you leave your job you'll also have to pay a penalty unless the loan is repaid in full.

    On top of that, you lose the growth potential that you had with a higher 401(k) balance. If you need a loan, it's usually better to find a personal loan or a home equity line of credit. If you must borrow from your 401(k), make sure it's for a necessity (medical bills, etc.), and not something more frivolous like an expensive car or a vacation.

  7. Consider Your Investment Strategy. Some investors, particularly those who are young, make the mistake of investing too conservatively. Investing a large portion of your 401(k) in stocks gives you much more growth potential, and you can increase your assets faster with a smaller investment.

    If you're older, or the risk of stocks is not for you, you should consider investing more money to make up for the loss in growth potential.

  8. Don't Withdraw From Your 401(k) Without Serious Thought. In most cases, if you withdraw money from your 401(k) before retirement (under 59 1/2 when you file your income tax), you will have to pay income tax on it that year, and you may be subject to a 10 percent early-withdrawal fee. Plus, you are taking away money that you'll need when you do retire.

    If, as a last resort, you must withdraw money from your 401(k), you may be able to do so without penalty if you can prove financial hardship. Many employers follow the IRS' safe harbor guidelines to define "financial hardship." Under these guidelines, the need must be immediate and you must have used all your other options first (including borrowing from your 401(k)). Once you can prove this, withdrawals can be made only for:

    • Certain medical expenses (for you, your spouse or your dependents)

    • Purchasing a primary residence

    • Certain post-secondary education expenses (for you, your spouse or your dependents)

    • Prevention of eviction from or foreclosure on your primary home

Recommended Reading

Roth IRA: If You Don't Have One, Here's Why You Should Seriously Consider One

Mutual Funds: The Basics (That Most People Still Don't Know)


U.S. Department of Labor

Fidelity Investments

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