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Taking Care of Mom and Dad: The Most Common Plans: 401(k)s

A 401(k) plan -- the numbers and letter refer to the section of the U.S. Tax Code that allows them to operate -- is a defined contribution retirement savings account set up by an employer. Workers can contribute money to the plan through direct deduction from their paychecks before they have to pay federal or state taxes on it. The money can then be invested in any of several options offered by the plan.

There are several variations on the basic 401(k) plan. Keogh Plans and Simplified Employee Pensions (SEPs) are similar but designed specifically for people who are self-employed or work for very small companies. 403(b) Plans are similar but offered by nonprofit organizations such as schools and hospitals. The basic functions of these other plans are essentially like a 401(k) -- though, in some cases, the other plans offer more flexible contribution terms.

The main appeal of these plans is that they are tax-advantaged. If your parents have them, they didn't have to pay taxes on the money they contributed...or on any investment profits on the money while it sits in the account. They do have to pay income tax on the money when they take it out; but, theoretically, this tax will be less than what they would have paid on the money when they were working.

Another appeal: Many employers match part of a worker's 401(k) contribution. If your parents' companies offered defined-contribution plans, they may have added anywhere from 10 to 100 percent of the amount your parents contributed.

Although 401(k) funds can be invested in almost any manner, most plans offer participants a small menu of mutual funds and other conservative investments from which to choose.

By the time you're helping your parents, you might think investment strategies for their retirement money aren't important. But, remember, the 401(k) money has to last as long as your parents do, so asset allocation (where you invest the money) is important. Here are a couple of useful tips to remember:

  • Don't use 401(k) funds to buy tax-free investments, such as municipal bonds (exempt from federal and sometimes state and local taxes) -- because you don't pay current taxes on 401(k) earnings, anyway. Tax-free investments often make sense for older people outside of a pension plan; inside of a tax-advantaged plan, they're usually better off with investments that provide higher returns.
  • Watch the administrative fees. They always hurt; but they especially hurt money that's going to be in the plan for a short time. If all of the investment options in the plan are mutual funds with high fees, ask the administrator (usually connected to the employer in some manner) to change the plan to include no-load or low-load mutual funds.
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