4 changes that make your 401(k) plan even better

Highway sign with the words Retirement-Next Exit

You should take advantage of recent changes to your employer's 401(k) plan that make it easier to save for retirement and easier for your family to keep your money after you die.

These improvements were part of the Pension Protection Act of 2006, which have been hailed as the most significant changes since the retirement program was created in 1981.

We think that's a little dramatic. A 401(k) plan still works like it always did. Money withheld from your paycheck is invested in stocks and bonds and grows into a tidy nest egg all tax free until you retire and start spending it.

But with companies doing away with traditional pension plans and the long-term future of Social Security in doubt, everyone has to save and be prepared to support themselves throughout retirement.

So here are the four changes in the 401(k) laws that can help you out:

Change 1. Let yourself be automatically enrolled..

If you start a new job, your employer can qualify for tax breaks if it signs you up for its 401(k) plan. In most cases the company will withhold 3% of your pay and place it into one of several types of investments.

We suspect lifecycle mutual funds will be the most heavily used. These funds buy lots of different stocks and bonds and what they buy changes as you grow older.

When you're young, it puts more of your money in riskier but potentially lucrative investments to build your savings as quickly as possible. As you get closer to retirement, lifecycle funds shift your money into less rewarding, but less risky investments, so you know your money will be there when you need it.

If your company signs you up, you have the right to drop out within 90 days after enrollment. But don't do it. This is supposed to help you get over the hump of having to enroll yourself, figure out how much you can afford to set aside and how to invest it.

Change 2. Get some advice.

The investment or insurance companies that manage your employer's 401(k) plan can now advise you on where to put your retirement money.

In the past all they could do was provide basic, impartial information on the dozens of different mutual funds your 401(k) plan offered. You had to pick which ones to buy and many workers who had never bought mutual funds or stocks before found the choices to be so intimidating that they set the enrollment papers aside and never signed up.

If that's you, take advantage of the advice you can now receive to sign up and take part. Your human resources office can tell you how to get that advice by phone or on-line.

Don't be surprised if a lifecycle fund tops these recommendations as well. You should be comfortable with that. Not only do those funds take much of the work out of having to manage your money, they also prevent you from investing too conservatively or too aggressively.

A recent study for John Hancock, which runs 401(k) plans for many companies, found that employees who put all of their money in lifecycle mutual funds from 2001 to 2005 posted better returns than plan participants who picked their own investments.

Of participants who chose their own asset allocations, 88.7% would have accumulated a higher ending balance if they had invested in a single lifestyle portfolio that corresponded to their risk score. On average, their annual investment returns would have been 2.96 percentage points higher.

Change 3. Automatically increase your contribution.

Saving is hard. And one of the biggest problems with taking part in a 401(k) plan is forcing yourself to set even a small portion of your earnings aside for the future.

The new law allows you to do it gradually, but automatically build up the percent deducted from your gross (before-tax) pay.

If you were automatically enrolled, your employer will begin by withholding 3% of your pay, increase that to 4% the second year, 5% the third year and 6% in your fourth year.

If you enroll on your own, or are already taking part in your 401(k) plan, you can sign up for automatic increases, too.

You always have the option of putting a hold on future increases. But now you have to call to stop saving more, not to begin saving more.

It's particularly critical to reach that 6% rate because the new law also offers employers incentives to match the first 1% of your savings dollar-for-dollar and then contribute 50 cents for each additional dollar you save up to 6% of your annual earnings.

If you're not saving enough to qualify for that, then you are literally leaving money on the table, as much as 3.5% of your annual income.

Change 4. Help your heirs avoid taxes on your savings.

After you die, a spouse has always been allowed to close your 401(k) plan and transfer the money to an individual retirement account without having to pay any taxes on that savings.

But if your retirement plan was passed on to a child, grandchild, or anyone else, that wasn't the case. Those beneficiaries were forced to withdraw all the money from the 401(k) plan, often in a single year, and pay taxes on the entire amount.

As of Jan. 1, 2007 all of your heirs will be allowed to move your retirement fund into an IRA. Make sure they realize this and are ready to take advantage of this change.

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