5 Biggest 401(k) Money Rules To Follow When You Open Your First Account
If your employer lets you open a 401(k) account, you can conveniently contribute to your retirement savings through regular paycheck deductions. Not only should this money grow over time, but you could also get tax benefits and even additional contributions from your employer. You’ll just want to avoid common 401(k) mistakes and instead follow these five money rules to get the most from your account.
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1. Know Your Tax Strategy
Depending on your employer, you could have access to both traditional and Roth 401(k) options. These have different tax consequences now and during retirement, and it’s possible to have both types of accounts.
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With a traditional 401(k), you don’t pay income taxes on your earnings and contributions until you withdraw them during retirement. This means you get tax benefits now, so you might prefer this option if you expect to be in a lower tax bracket during retirement.
A Roth 401(k) requires paying income taxes now and not getting an immediate tax break. However, you can withdraw earnings and contributions tax-free during retirement as long as you meet certain requirements. This makes a Roth 401(k) ideal if you expect to be in a higher tax bracket during retirement.
2. Take Advantage of Your Employer’s Match
According to the IRS, you can put $22,500 toward your 401(k) in 2023 — plus another $7,500 in catch-up contributions if you’re at least 50. Many employers will match your contributions to a certain percentage of your salary.
Most often, your employer will offer a 100% match on the first 3% to 6% of your pay. In other cases, they may use a multitier or variable formula or put an annual cap on matches.
Since these matches are essentially free money from your employer, it’s worth at least contributing enough to your 401(k) to get the maximum match. You’ll also want to understand your employer’s vesting schedule because leaving your job too soon could mean giving up all or some of your matched contributions.
3. Choose the Right Investments
Your 401(k) plan likely lets you invest in various bond and stock mutual funds and exchange-traded funds rather than individual securities. These investments have different potential returns and risks, with Vanguard cautioning that stock ETFs and stock mutual funds tend to be faster growing but also more volatile than bond funds.
When choosing your 401(k) investments, research each option thoroughly and consider your risk tolerance and desired return. It can also help to experiment with 401(k) retirement calculators to see how your choice of investments could affect your savings. Additionally, make sure to diversify to reduce the impact of losses and look into investment fees so that expenses don’t significantly cut into your returns.
4. Avoid Touching the Money
Early 401(k) withdrawals are becoming increasingly common for Americans, and some take out 401(k) loans if their plans allow it. While it can be tempting to take money from the account, it means missing out on potential earnings. Additionally, early 401(k) withdrawals and unpaid 401(k) loans can get costly since you’ll pay any taxes due and possibly a 10% penalty.
Rather than touching the money, consider other borrowing options, such as credit cards, home equity loans or money from family. And if you do need money from your 401(k) during an emergency, see if your employer allows loans and be sure to repay yours as agreed to avoid negative tax effects.
5. Don’t Ignore Other Retirement Investment Options
While a 401(k) is valuable, there are some drawbacks to relying on just one investment account. You might prefer having more investment options or paying lower fees. You may also want some tax diversification or the option to contribute beyond annual 401(k) limits.
One option is to supplement your 401(k) with a traditional or Roth IRA with similar tax benefits but more flexibility for control and investment options. These accounts have a lower 2023 contribution limit of $6,500, plus another $1,000 if you’re at least 50. You can also look into annuities and regular brokerage accounts for stocks and bonds.
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