401(k)s: 10 Things You Must Know About These Retirement Savings Plans
These accounts can be a great way to save for retirement while giving you a tax break now. But beware of the fees plan providers charge for 401(k)s.
When you start a new job, one of the first decisions you'll likely make is whether to participate in the company's 401(k) plan. The earlier you start saving in a 401(k), the better. But no matter how old you are, it's never too late to contribute more to your account and bolster your future retirement security.
Here are 10 things you need to know about these retirement plans.
You Get a Tax Break for Contributing to a 401(k)
With its name derived from the tax code, the 401(k) is an employer-based retirement savings account, known as a defined-contribution plan. You contribute pretax money from your salary, which lowers your taxable income and helps you cut your tax bill now. For instance, if you make $4,000 a month and save $500 a month in your 401(k), only $3,500 of your monthly earnings will be subject to tax. Plus, while inside the account, the money grows free from taxes, which can boost your savings.
You May Be Auto Enrolled in a 401(k)
An increasing number of companies are enrolling employees automatically into their 401(k) plans, allowing workers to opt out if they choose. According to research by the Plan Sponsor Council of America, 69% of companies used auto enrollment and 69% of defined contribution plans offered an "auto escalation" feature in 2019. Often the initial contribution rate for auto enrollment will start at 3% of the worker's pay. Auto escalation increases the default contribution rate over time, such as by 1% per year, until the employee is contributing a certain amount, typically 10% of their salary annually.
Workers may opt out, or they may choose to set a higher (or lower) rate of savings. But beware: Employees who rely solely on the default rates may not end up with a sufficient nest egg, as most experts recommend saving a minimum of 12% and up to 15% of your pay a year.
There are Contribution Limits for 401(k)s
The IRS sets an annual limit on how much money you can set aside in a 401(k). That limit can change because it is adjusted for inflation. For 2021, you can put away $19,500. Those 50 or older by year-end can contribute an extra $6,500. Check out the Financial Industry Regulatory Authority's 401(k) Save the Max Calculator, which will tell you how much you need to save each pay period to max out your annual contribution to your 401(k). If you cannot afford to contribute the maximum, try to contribute at least enough to take full advantage of an employer match (if your company offers one).
Your Company May Match Your 401(k) Contribution
Many employers will help you save in your 401(k) by matching an employee's contribution up to a certain percentage, perhaps 50 cents for every dollar you contribute up to 6% of your pay. Be clear on what the company's formula is.
Some companies will provide contributions to employees' accounts, regardless of whether employees contribute their own money. And some employers may provide the match in company stock. Whichever way the company helps you save, ask whether there is a vesting schedule for that employer-provided money. You may have to work for the company for a certain amount of time before that money becomes 100% yours.
There Are Fees You Pay for Your 401(k)
Unfortunately, 401(k) plans come with fees but many savers don’t realize this. According to TDAmeritrade’s January 2018 Investor Pulse Survey, 37% of Americans don’t know that they pay any 401(k) fees, 22% don’t know if their plan has fees, and 14% don’t know how to determine the fees. Typically larger plans will have lower fees but the number of enrollees and the plan’s provider can also affect the cost. Typically, fees will range from 0.5% to 2% of the plan assets.
Pay attention to each fund's expense ratio, which is a measure of a fund's operating expenses expressed as an annual percentage. The lower the expense ratio, the less you’ll pay to invest. A total expense ratio of 1% or less is reasonable. Look at your 401(k) plan's website to find a fund's expense ratio.
The good news is that your plan may give you access to lower-cost institutional shares, which are cheaper than different share classes of the same investment bought through an IRA. The average equity mutual fund expense ratio for stock funds in 401(k)s was 0.50% in 2020, according to the Investment Company Institute. One way to cut costs: Look to see whether your plan offers index funds, which tend to be cheaper than actively managed funds.
On top of investment fees, expect to pay administrative fees. Ask your benefits manager for details on your plan's costs. In 2012, the federal government issued a rule that requires companies to do a better job of disclosing all the fees you pay for your 401(k). Also, check BrightScope.com, which rates 401(k) plans. The site can show you how your 401(k) stacks up against other companies' plans. And if your plan isn't competitive with other company plans, start asking your company's benefits manager about ways to improve the plan.
You Can Choose From a Selection of Funds in Your 401(k)
In a 401(k), your employer will select the investment choices available to employees. You, as the employee, can then decide how to allocate your contribution among those available options. If you don't make a selection for your contribution, your money will go to a default choice, likely a money-market fund or a target-date fund.
Most plans will offer actively managed domestic and international stock funds and domestic bond funds, plus a money-market fund. Many plans also offer low-cost index funds. (Check to see if your plan offers any of The Best Funds for Your 401(k).)
Also common on the 401(k) menu: target-date funds, which nearly 70% of plans offer. Over time, this breed of fund typically shifts from a stock-heavy portfolio to a more conservative, bond-heavy portfolio by its target date.
You May Have a Roth 401(k) Option
Another choice to consider: a Roth 401(k). Not all plans offer the Roth option, but if yours does, you are allowed to put in after-tax money in exchange for tax-free growth and tax-free withdrawals in the future.
You can choose to divide your annual contribution between the traditional 401(k) and the Roth 401(k). Any employer match will go into a traditional 401(k).
According to a survey conducted by global advisory firm Willis Towers Watson, seven in 10 employers offered a Roth option within their 401(k) in 2018. You'll have to pay tax based on the investments' value at the time of the in-plan conversion. But beware: Unlike IRA Roth conversions, you can't undo a 401(k) Roth conversion -- the decision is irrevocable.
You Can Withdraw Money Early from a 401(k)
Money you stash in a 401(k) isn't meant to be touched until retirement, and any money withdrawn before you turn 59 1/2 could be subject to a 10% early-withdrawal penalty. But if you leave a job as early as age 55, you can tap the 401(k) penalty-free.
Company 401(k)s also generally allow participants to borrow from their accounts. You may have to pay a fee to take a loan. Plus, you'll be charged interest on the amount you take out. But you'll basically be paying interest to yourself because the money goes into the account. Watch out if you have outstanding loans when you leave a company -- the loans will have to be repaid within 60 to 90 days. If not, the amount of the loan will be considered a taxable distribution.
You Can Roll Over a 401(k) Account
Workers generally have four options for their 401(k) when they leave a company: You can take a lump-sum distribution; you can leave the money in the 401(k); you can roll the money into an IRA; or, if you are going to a new employer, you may be able to roll the money to the new employer's 401(k). (Note: Those with balances of less than $5,000 may not get the option to keep their money in their old plan.)
It's usually best to keep the money in a tax shelter, so it can continue to grow tax-deferred. Whether you roll the money into an IRA or a new 401(k), be sure to ask for a direct transfer from one account to the other. If the company cuts you a check, it will have to withhold 20% for taxes. And whatever money isn't back in a retirement account within 60 days will become taxable. So if you don't want that 20% to be considered a taxable distribution, you'll have to use other assets to make up the difference. (Once you file your tax return for the year, you'll get that withholding back.)
Eventually You Must Withdraw Money from a 401(k)
Uncle Sam won't let you keep money in the 401(k) tax shelter forever. As with IRAs, 401(k)s have required minimum distributions. You must take your first RMD by April 1 in the year after you turn 72. You will have to calculate an RMD for each old 401(k) you own. Once you've determined the RMD, the money must then be withdrawn separately from each 401(k). Note that unlike Roth IRAs, Roth 401(k)s do have mandatory distributions starting at age 72.
If you hit that magic age, you are still working, and you don't own 5% or more of the company, you don't have to take an RMD from your current employer's 401(k). And if you want to hold off on RMDs from old 401(k)s and IRAs, you could consider rolling all those assets into your current employer's 401(k) plan.