Sunday, November 01, 2009

Should I participate in 401k? The answer is YES !

Should I participate in 401k? This is the BIG question that lingered in my mind for several years, before I decided to contribute towards 401k. For many years, I was thinking that 401k is for people who wants to 'settle down' in US. Also, I thought only Green Card holders or US citizens can participate in the 401k program. I didn't realize that even folks working in H1B visa can participate in 401k. Later, I repented that I should've participated in 401k, much earlier. If you are incognizant to the benefits of participating in 401k program, this blog post is for YOU.

I went from India to work for a start up company in US. They didn't have any 401k plan at all. After a few years, they introduced 401k plan - however, there was no employer contribution. So, I didn't pay much attention to 401k, when it was introduced in my startup. It was during my 5th year, I realized that 401k is WEALTH, irrespective of whether you're carrying that to your retirement or have to close in-between, due to your Return to India (R2I). The company that I joined during my 5th year had an 'employer match' for the 401k contributions. So, it was highly irresistable and I started making contributions.

The contributions that you make to 401k are tax exempted. If your employer matches your 401k contributions, you should definitely consider participating in the plan. Even if you have to close your 401k account in between due to your R2I, you'll still have made decent money/profit.

For example, let us assume that you are contributing $100 to 401k, every month. If your employer matches your 401k contributions, then the deposit to your 401k account every month would be $200 ($100 from you + $100 from the employer). In 2 years, you would've got at least $4800 (24 * $200). 401k contributions are typically re-invested in stocks, mutual funds, bonds etc., So, the performance of the stock/bond market will have an influence on your account balance.

When you decide to R2I, you have the option of keeping your 401k account active (without any contributions to it) till your retirement age. However, if you decide to close your 401k during your R2I, there will be a 10% penalty + XX % tax (based on your tax bracket). Let us make two assumptions - (1) Your investment's value hasn't increased or decreased due to fluctuations in stock market (2) You fall into the 33% tax bracket. So, your account balance will be $4800. The NET amount you've to lose due to 33% tax + 10% penalty would be $2064 (i.e., $4800 * (33 + 10)/100). You would get $2736 in hand during your R2I, if you had participated in 401k.

Let us assume that you haven't contributed to the 401k, at all. Your $100 (that you might have potentially contributed to 401k), will be tax deducted and deposited into your bank account as part of your salary every month. Assuming that you fall in 33% tax bracket, every month, you'll get an additional deposit of $67 (i.e., $100 * (100 - 33)/100). At the end of two years, you would've got only $1608 (i.e., 24 * $67), if you are not participating in 401k.

Do you know how much additional money you could've got by participating in 401k? $1128 !!! (i.e., $2736 - $1608). Also, there is a high potential for you to earn additional money through the appreciation of stocks, mutual funds, bonds, etc., Imagine how much additional wealth you can accumulate by participating in 401k plan. I personally felt that my short 401k participation was very handy when I decided to R2I. It took care of all the initial settling costs.

Should you participate in 401k? The answer is YES! YES! YES!

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3 comments:

  1. The above savings work only if employer is making equal contribution. If there is no employer contribution, then there is a potential to loose the penalty (10%).

    Second, you need to take exchange rate into account as well. As mentioned in other post - there is a possibility that you may be transferring a bulk of money at one instant and exchange rate at that time could have a significant upside or downside to it.

    Now, what is the solution?
    There is an option to take the money after you R2I. I think till 2 years you could withdraw the money without paying tax in India. You might have to consider that so that you pay less on taxes. Also, you could transfer the amount over a period of time (monthly or quarterly) to average the exchange rate as well.

    Btw, "timing" is critical. If someone has closed when the stock market hit the bottom, then one might loose lump of his/her savings. Remember! there are funds which has lost 40%-50% during the recent recession.

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  2. Yes. You'll see the magic if your employer matches your contributions.

    "If your employer matches your 401k contributions, you should definitely consider participating in the plan. Even if you have to close your 401k account in between due to your R2I, you'll still have made decent money/profit"

    The 'fluctuations' in the stock/bond market will heavily influence your profit. You have to be cautious about it.

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  3. Also if employer's contribution vest immediately it works. Oftentimes, employers contribution vest over period of time. than if (employers contribution * % vested by your r2i) is <10% than you lose money.

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