Saving for Retirement

Your 401(k) Just Got Better

It's easier to save and to get advice on where to invest your money.

By Mary Beth Franklin, Senior Editor

From Kiplinger's Personal Finance magazine, October 2006

While much of the country tried to keep cool during a brutal August heat wave, Congress enjoyed a burst of energy and passed the most sweeping changes to 401(k) rules since these tax-deferred savings plans debuted 25 years ago. It's a good thing, too, because traditional pensions continue to disappear, shifting the burden of saving for retirement from employers to workers. The new law makes it easier for you to sock away more money for retirement and, beginning next year, to get personal advice from your plan provider on how to invest it.

Automatic contributions. To increase 401(k) participation and protect procrastinators from themselves, the new law encourages companies to enroll workers automatically in their 401(k) plans. You can opt out, but why would you? This change should mitigate the inertia associated with retirement savings. According to the Employee Benefit Research Institute, automatic enrollment will increase 401(k) participation from about 66% of eligible workers to more than 90%.

Beginning in 2008, if you are automatically enrolled in your company retirement plan, your employer may deposit 3% of your pay in your 401(k) account to start and increase your automatic contributions each year until the set-aside reaches 6%. Again, you can just say no, but that wouldn't be wise. Many retirement-plan providers recommend saving at least 15% of your pay (including any employer matching contributions) to accumulate adequate retirement savings.

The U.S. Labor Department is expected to issue guidelines making target-date retirement funds -- which invest in balanced portfolios of mutual funds that grow more conservative as you near retirement -- a default investment that's preferable to more-conservative money-market and stable-value funds. That way, even investors who never select an investment strategy on their own will be on the right track.

Higher savings limits. The new law makes permanent the higher contribution levels for IRAs and 401(k)s that were scheduled to disappear after 2010. Higher limits also apply to other workplace-based retirement plans, such as 403(b)s for teachers and 457 plans for government workers.

The annual contribution limit for an IRA, $4,000 in 2006, will rise to $5,000 in 2008 and be indexed to inflation after that. Meanwhile, contributions to 401(k) plans, currently limited to $15,000, had been scheduled to drop back to $14,000 after 2010. Now the higher level will remain until inflation triggers future increases.

Catch-up contributions if you're age 50 or older are also here to stay. If you qualify, you can continue to add an extra $1,000 to your IRAs and an additional $5,000 to your 401(k) plans.

The new Roth 401(k), which allows you to contribute after-tax dollars in exchange for tax-free withdrawals in retirement, is expected to catch on more quickly. Employers had been slow to adopt the Roth 401(k), introduced in 2006, for fear it would disappear after 2010. Now that it's permanent, there's no excuse for foot-dragging. The Roth 401(k) is a great option for young workers who will benefit from decades of tax-free growth or for anyone who believes taxes will be higher in the future as retiring baby-boomers increase the demand on Medicare and other federal programs.

The law also permanently extends the Saver's Tax Credit that was due to expire at the end of this year. Low- and moderate-income workers get a tax credit of up to $1,000 for contributing either to an IRA or a 401(k). Although teens under 18 and full-time students can't take advantage of the credit, it could reduce or wipe out the tax bill for many entry-level workers and retirees who work part-time. You'll also be permitted to designate that all or part of your tax refund be deposited directly into an IRA.

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