Everything to Know About 401(k)s
Updated: Jul 7
As an employee in any industry, it is important to know about the most common investment vehicle for Americans: 401(k) accounts. Having basic knowledge on this savings tool can make all the difference when it comes to your retirement.
Knowing the maximum annual contributions to a 401(k) plan is important. Employees can choose their savings rate as a percentage of their salary each year. Some experts recommend saving 12% to 15% of your annual salary. This is often more than an employer’s set default rate. However, the IRS sets an annual limit on how much money can be set aside in a 401(k) and this amount varies from year to year, due to inflation. The maximum contribution limit for 2021 for a 401(k) or 403(b) is $19,500.
For older workers (ages 50 and up), a catch-up contribution of $6,500 exists in 2021, allowing employees to put even more income into their plan as they get older. As long as you remain employed for a company with a 401(k) plan, there is no age limit in which you have to stop contributing. Your company may also offer to match their employee’s contribution up to a certain percentage or dollar amount. It is important to know how much your employer contributes and the method in which they do so.
An important benefit of 401(k) plans is the tax break for contributions. Money is contributed from a person’s salary pretax, thus lowering their taxable income. Money inside a 401(k) account grows and is not subject to taxes (helping to increase savings), until money is withdrawn during retirement.
It is important to have a withdrawal plan in place before retirement and know the age at which you can make penalty-free withdrawals. With a traditional 401(k) plan, you can withdraw money early but may be subject to penalties. Borrowing from your 401(k) account will incur interest expense and potentially fees. Some exceptions exist for penalty-free early withdrawals. Examples include a permanent disability, a military reservist being called to active duty, and if needed to pay unreimbursed medical expenses exceeding 10% of adjusted gross income.
Be aware that 401(k)s have required minimum distributions (RMDs). The first required withdrawal needs to be taken by April 1 in the year after turning 72. A calculation for RMDs must be made on each 401(k) that you own, and the money must be withdrawn separately from each account. Assets from older 401(k)s can be rolled into a current employer’s 401(k) plan to mitigate the problem of having multiple RMDs.
More and more companies are automatically enrolling employees into their 401(k) plans with an initial contribution rate often set at 3%. This contribution percentage may increase over time until a worker is contributing a certain amount of their salary annually. If this is the case, employees may choose to pull out of this automatic plan or set different savings rates. Either way, being aware of this policy is important to make good retirement investment decisions.
Despite the savings benefits, 401(k) plans do have some draw backs. 401(k) plans come with fees that typically range from 0.5% to 2% of plan assets. There are also administration fees that come with 401(k)s. It is crucial to be aware of these fees and plan to save accordingly. Looking at a fund’s expense ratio can also be beneficial. A ratio of 1% or less is appropriate. Furthermore, your investing will be limited based on the financial firm your employer contracts to manage the 401(k) plans. The average 401(k) will offer 19 funds to choose from, which may sound limited in comparison to the 7,000 tradable equities on the U.S. stock exchange. Also, tax rates in the future are uncertain, and may be higher than what you would pay if you did not defer the tax. Thoroughly understanding your retirement program is the best way to ultimately plan for your future.
When choosing investment tools, employers attempt to select the best investment choices available for their employees. The responsibility of the employee is to decide how to allocate their own contributions among the investment choices available. If an employee does not make this selection, their money will most likely go into a money-market fund or target-date fund.
Actively managed domestic and international stock funds, domestic bond funds, and a money-market fund are offered by most 401(k) plans. Many plans also offer low-cost index funds.
Another choice that is sometimes available through employers, is contribution to a Roth 401(k). This provides a tradeoff between allowing you to contribute after-tax money with tax-free growth and tax-free withdrawals in the future. With this option, annual contributions can be divided between the traditional 401(k) and Roth 401(k). Important to note is that once you contribute to a Roth 401(k), the action is un-doable. Contributions cannot be switched back to a traditional 401(k). Matching contributions from an employer only count towards traditional 401(k) plans.
If you decide to participate in a 401(k), it is essential to understand what to do with your money once you leave a company. When leaving a company, there are usually four options of what to do with your savings. These options are leaving the money in the 401(k) which may incur additional fees, taking a lump-sum distribution, rolling the money into an IRA, or rolling the money to a new employer’s 401(k). Experts suggest keeping the money in a tax shelter, so it is helpful to ask for a direct transfer from one account to another when rolling the money into an IRA or new 401(k) plan.
Understanding the facts of 401(k)s is crucial for planning. Asking your employer or financial advisor about your investment options and current plan is a beneficial step to take for your retirement, even if it is a long way down the road. Ultimately, the earlier you begin to plan and save for retirement, the better off you will be for your future.