With a 401(k) plan, retiring as a millionaire may not be just a dream
The newspaper ads may have been talking about individual retirement accounts (IRAs) and inflated dollars when they said, ''You can retire a millionaire,'' but with the 401(k) ''salary reduction'' plan, that prospect is even more likely.
Contributions to a 401(k) are all made before any federal or state income taxes are deducted, so you can probably afford to make larger contributions to it than might be possible with an IRA. The annual limits on contributions are also $28,000 higher than the $2,000 permitted in an IRA.
This, plus the power of compounded interest, makes it possible - given enough years of saving - that a well-invested 401(k) could provide a million dollars or more at retirement.
Selecting a good investment, however, may be difficult for someone who has not had to worry about saving for retirement before because he considered the company pension and social security would provide all the secure retirement he wanted.
As with any investment, financial planners recommend aganst putting all your 401(k) eggs in one basket. ''You want to have a mix of some sort, you want diversification,'' argues Christopher Croft, vice-president and manager of financial planning at Bailard Biehl & Kaiser, a planning firm in San Mateo, Calif.
With most 401(k) plans, the employee can diversify by choosing among a fixed-interest annuity, a stock mutual fund, a money market fund, and perhaps company stock. This also applies to 403(b) plans available to teachers and employees of nonprofit organizations, except that company stock is not available.
Mr. Croft suggests a portion of the 401(k) or 403(b) investment be spread among at least two of these selections so that ''you always have some margin of protection.''
Part of the basis for choosing how much to put in each of these alternatives is the worker's age. ''The younger you are, the more risk you can afford to take ,'' Mr. Croft says. So someone in his 20s, 30s, or even early 40s might want to put the bulk of his money in the stock or money market fund, depending on the performance of the stock market at the time. As a person gets older, he may want to shift the mix more heavily to the annuity.
The individual's temperament must also be taken into acount here. If any participation in the stock market makes you uneasy, you're better off in an annuity or a money market fund.
Even though companies setting up 401(k) plans often have participation rates of 80 percent or better - particularly if the firm also makes a contribution - there are some people and companies for which these plans may not be an advantage.
''If the firm has a lot of younger employees, it may be a problem,'' Robert Gorman, director of marketing at CIGNA, an insurance company in Hartford, Conn. Younger employees may occasionally want to get at their savings for things like furniture, children's clothes, or a new car - all of which are needed, but do not qualify as ''hardship'' as defined in forthcoming Internal Revenue Service regulations. In these regulations, hardship will include a down payment on a primary residence, emergency medical bills, and college tuition.
But even these people can start out by putting 1 or 2 percent of their salary in a 401(k) and, with the advantages of pretax savings, it will result in little reduction in their take-home pay.