was a time not too long ago when employers saved the money to pay
for an employee's pension at retirement. But traditional company-paid
pension plans have virtually disappeared today.
In their place is a new retirement system in which employees
save part of their wages into a "401(k) account," and
the employer may then match these contributions into the employee's
What Is a 401(k) Plan?
These plans are named after the section of the Internal Revenue
Code that authorized them in 1978. They are popular with employers
because, unlike company-paid pension plans, they shift much of
the financial burden of paying retirement benefits to the employee.
Unlike a defined-pension plan that guarantees a fixed monthly
benefit at retirement, 401(k) plans guarantee nothing. The benefits
they provide depend entirely on how much cash is in the account
An employee who is at least 21 years of age and who has been
on the job for at least one year should be eligible to join a
company's 401(k) plan and make "salary reduction" contributions.
These contributions are tax-deferred except for Social Security
and Medicare taxes.
About 85% of employers "match" an employee's contribution.
Some 18% of employers match dollar for dollar, about ten percent
match between 50 cents and a dollar, about 45% match 50 cents
to each employee dollar, and about five percent match 25 cents
to the dollar.
The maximum annual deductible contribution for employees is adjusted
for inflation each year and it is currently about $9,500, or 15
percent of salary, whichever is less.
The total contributions of the employee and the company to an
account may not exceed 15% of salary or $22,500, whichever is
Differences Between a Pension and a 401(k) Plan
A key difference between a traditional pension plan and a 401(k)
plan is that traditional pension plans are completely paid for
by the employer and employees do not participate in the investment
decisions of the plan. However, a typical 401(k) plan is mostly
paid for by the employee and the plan is self-directed.
That is, the employee also makes the investment decisions (within
the limits of the plan).
Under U.S. Labor Department rules, employers who offer 401(k)
plans are not responsible for employees' poor investment decisions
as long as they offer at least three diversified investment options
and allow shifts of assets among the options at least once each
A typical 401(k) plan might include the following choices:
Fixed savings funds (a guaranteed investment contract, or GIC,
a money market account, or a savings account).
Bond mutual funds.
Stock (equity) mutual funds.
Employer's company stock.
How to Invest in Your 401(k) Plan
The most important point to keep in mind is that 401(k) plans
are for long-term retirement savings. Therefore, most people should
put at least 80% of their money into stock mutual funds.
Over the long term, stock funds have outperformed fixed-income
investments by about three to one. Over the past 15 years, good
stock funds have returned about 15% a year, allowing you to double
your money every five years.
When You Leave Your Employer
In a 401(k) plan your employer's matching contributions fall under
the plan's vesting schedule. Your contributions are always 100%
vested. You are also 100% vested if you become disabled or the
employer's plan is terminated.
The two principal vesting schedules are:
Instant vesting. No vested interest in employer contributions
for five years, then the employee is 100% vested thereafter.
Gradual vesting. No vesting for the first two years, then a gradual
accumulation of 20% a year; in seven years the employee becomes
If you plan to leave your job, you should check your company's
vesting schedule and your plan's anniversary date in order to
maximize your vested interest.
You should also plan to roll over the money in your 401(k) plan
to an IRA. Current laws require your employer to withhold 20 percent
of your money for taxes if you don't roll over the money directly
to an IRA.
Your best bet is to roll over your 401(k) assets into your current
IRA, or open a new IRA and ask the IRA trustee to write your employer
and have your money transferred directly to the IRA.
If you do take possession of your money, you have 60 days to
roll it over into an IRA, but your employer must still withhold
20 percent for taxes. You can later get a refund on your tax return
if you make a complete rollover of the lump-sum distribution.
If you fail to roll over the money into an IRA, you'll face ordinary
income taxes on the amount received and, if you are under age
59 1/2, you will also incur a federal tax penalty of ten percent.
Many states also impose a tax penalty. In California, for example,
the penalty is 2.5%.
If you are 55 or older, however, and you leave your job (you
don't need to retire), you can cash out your 401(k) assets without
a tax penalty and you can still roll over some of the assets to
your IRA (IRAs don't have this feature until you reach age 59
Borrowing from a 401(k) Plan
Almost two-thirds of employers allow employees to borrow up to
50 percent of their vested 401(k) plan account balance, up to
a maximum of $50,000. Borrowing from your 401(k) plan is usually
permitted for emergency medical expenses, home purchases, "hardships,"
and college expenses.
The money you borrow is not taxable income because you must repay
the loan, usually through monthly or quarterly payroll deductions
over five years. If you use the money to purchase a home, you
might be able to take as long as 15 or 20 years to repay the loan.
Your loan repayments and interest costs, like most other loan
repayments, are not tax deductible.
The bad news is that if you leave your employer for any reason,
the entire loan becomes due and payable on your departure. If
you can repay the loan from other funds, you should certainly
If you fail to repay the loan, the unpaid balance will be considered
an "early withdrawal" from the plan and (unless a new
employer agrees to take it on) will be subject both to regular
income taxes and, if you are under age 59 1/2, the tax penalties
Start Your Own Stock Fund
If all mutual funds look to you like alphabet soup, if you'd like
to avoid stock brokers and financial planners, or if you'd like
to build your own retirement portfolio, doing it yourself may
be the best route for you. Investing in so-called No-Load Stocks
is a great way to build a retirement nest egg. The name "no-load"
comes from the fact that when you buy stocks directly from a company
you are not charged fees or commissions.
In addition, some companies discount the price of the shares
they sell you so that you are buying below the current market
price. Some corporations even offer special deals on their products
or services to their shareholders.
You can also start a program for your children or grandchildren,
or later transfer some of your shares to them. For everyone, it's
a great way to learn about shareholders rights and opportunities.
Charles Carlson, author of several books on buying stocks directly
from companies, says "Buying stocks without a broker is like
a free lunch on Wall Street. It's the single best way for the
do-it-yourself investor to accumulate stocks in quality companies."
Buying stock directly from a company is nothing new; many companies
sell shares to current shareholders through direct purchase or
dividend reinvestment plans. The catch: you must first already
own one or more shares in order to play.
Here are some ways to get started:
Direct Purchase Plans
One way to buy that first share of stock is to pick out some blue-chip
companies that sell initial shares directly to the public. Once
you buy a share, most of these companies will allow monthly purchases
of $10 to $50 or more. Dozens of large companies sell initial
shares directly to the public; the chart at the bottom of the
page lists a few of them.
First-Time Purchase Plans
But how do you get that first share of a company's stock if the
company will only sell directly to current shareholders? There
are a variety of ways. You can buy the first few shares from a
discount broker, but there are a number of groups that will help
you buy that first share or two yourself.
National Association of Investors Corporation (NAIC)
This is the group that offers information on starting and operating
an investment club. NAIC has agreements with 142 companies to
sell first shares. To use its services, you must become a member
of NAIC and pay a $35 annual fee. You then also receive a subscription
to its magazine, Better Investing, and a manual on investors'
Here's how NAIC's first-share plan works: If a stock sells for
$25 a share, NAIC requires an additional $10 to be added to that
price, so $35 is earmarked for investment. The additional $10
is to allow for price fluctuations and assures that a minimum
of one share plus a fraction of a share is purchased. Your order
is at the prevailing price at the time of purchase.
You will not receive a stock certificate for each purchase, but
rather a statement showing the number of shares, including fractional
shares, and any dividends credited to your account. NAIC charges
another $5 as a service fee for each company.
To learn more about NAIC's program, call 1-810-583-6242, or write
NAIC, 711 West 13 Mile Road, Madison Heights, MI 48071.
This firm offers a "matchmaking" service that enables
people with shares to sell to hook up with those who want to buy
them. First Share charges an $18 annual membership fee, and $10
for each transaction. The current stockholder who sells the shares
can also charge an additional $7.50 per share over the market
price. To learn more about First Share, call 1-800-683-0743, or
write to 103 South Second Street, Box 222, Westcliffe, CO 81252.
Once you own some shares in a company, many will allow you to
join a Dividend Reinvestment Plan, or DRIP, and automatically
use your dividends to purchase more shares directly from the company.
Often the shares sold to you will be at a discount from the prevailing
market price, and most companies with DRIPs will allow you to
purchase additional shares over and above those you can buy with
your dividends. Most will also sell your shares at any time.
Hold the Stock in Your Name
If you want to avoid brokers' commissions and fees, you will
need to hold any stocks you buy in your own name. Most people
who buy stocks from a broker have the broker hold them in "street
name," or in the name of the broker for the buyer. Most companies
that sell stocks directly and offer DRIP plans will keep the shares
in your name, or you may take delivery and keep them in a safe
Many companies offer IRA programs and act as your IRA trustee.
They can also make automatic withdrawals from your checking account
to purchase more shares. The monthly minimum for such automatic
IRA purchases is usually between $25 and $50.
How to Learn More
I recommend Charles Carlson's Buying Stocks Without a Broker (McGraw-Hill,
$16.95) and his No-Load Stocks (McGraw-Hill, $14.95). Carlson
has also authored the Directory of Dividend Reinvestment Plans,
a 1995-96 workbook. It lists all the companies that sell stocks
directly to individuals and outlines how you can participate in
DRIP plans. It costs $15.95, which includes shipping and handling.
To order the Directory, call Charles Carlson directly at 1-219-931-6480
or write to him at 7412 Calumet Avenue, Hammond, IN 46324. Carlson's
other books mentioned above are in the book stores.
A Note of Caution
Buying shares directly from a company and using a DRIP plan to
reinvest your dividends is a successful strategy only if you believe
the company will do well in the future and you intend to hold
your shares long-term. These plans, however, do allow you to start
building an investment program at a very low cost. You'll be surprised
at how your portfolio can grow in value over time even if you
invest just a few dollars each month.
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