Question: I have been told that the
government changed the laws regarding vesting in 401(k) plans and that employer
contributions are now always 100% vested. Is this true? TB: The vesting rules for most 401(k) plans have not changed.
What you have heard about is a new type of 401(k) plan that became an option for employers
effective January 1, 1999. It is called a "design-based safe harbor." Employers
that change to this type of plan are exempt from the special non-discrimination tests that
apply to 401(k) plans.
One of the design requirements of this type
of plan is 100% vesting of employer contributions. This special vesting requirement
applies only to this type of plan.
Question: If I invest in stocks that
pay a dividend, is the dividend added to my investment funds? Is that income considered
part of my 15%? Is it advantageous to use a 401(k) to invest in stocks that pay a
dividend, because I won't get taxed immediately on that dividend income?
TB: Most 401(k) plans do not permit
you to invest in individual stocks, but in mutual funds or other collective types of
funds. If this is the case for your plan, then the issue is whether you put your money
into funds that have income, rather than growth, as their objective.
Any investment income (interest, dividends,
capital gains, etc.) on your 401(k) money should be added to your account. Investment
income does not impact the amount that you are permitted to contribute.
The fact that dividend and interest income
is tax-deferred in a 401(k) plan is a plus. Advisors who suggest this type of investing
inside the 401(k) also recommend holding your growth investments outside the plan where
you can benefit from the lower capital gains tax rate. This advice is reasonable for an
individual who has a significant investment portfolio both inside and outside the 401(k).
However, most 401(k) participants are not in
this position. The bulk of their investments are inside the 401(k). If this is your
situation, then you need to focus on accumulating a large enough nest egg to retire rather
than on the fact that interest and dividends inside a 401(k) aren't taxed. There are many
factors that are just as important as taxes, or even more important, in determining how to
best invest your money both inside and outside the 401(k).
Question: I would like to take out a
loan against my 401(k) to use as a down payment on a home, to avoid the penalty of a
hardship withdrawal. The bulk of my account is from a pension plan we had prior to the
401(k), which is not eligible for loans because it isn't "new" money. Why
distinguish between "old" and "new" money?
TB: The terms "old" and
"new" money tend to be applied loosely and inconsistently. In your case, we need
to focus on the fact that all employers have the right to determine what money may be
borrowed, and whether to permit loans at all. Many employers do not allow 401(k) loans
because they are tough (and expensive) to administer.
When employers do permit loans, it is common
for the amount of the loan to be limited to the employee's contributions, including any
investment gains or losses. Borrowing employer contributions to a 401(k) plan (whether
from the current employer or transferred from a previous plan) is commonly prohibited
because the employer wants this money to be used for retirement benefits.
To find out specifically why your earlier
plan money is not eligible for the loan, I suggest you contact your employer directly.
Question: Why is it not efficient to
use a 401k to invest in municipal bonds?
TB: Municipal bonds pay a lower
return than corporate bonds, but are able to attract investors because the income is not
taxed. However, if you hold municipal bonds in a 401(k) plan, the interest will eventually
be taxed when you start making withdrawals from your account at retirement. This is why,
in your 401(k) investments, it would be preferable to forego municipal bonds and invest in
corporate bonds for their higher return.
Ted Benna, creator of the first 401(k) retirement savings
plan, will answer your most intriguing questions every Friday. With over 30 years of
experience as an employee benefits consultant, Ted is a nationally recognized expert on
benefits issues. He has authored two books, Helping Employees Achieve Retirement Income
Security and Escaping the Coming Retirement Crisis, and is President of the
401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and
participants. His articles and comments have appeared in numerous publications, including The
New York Times and The Wall Street Journal.
 Read Ted Benna's Biography
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