7 things you need to understand about your 401k
How well do you know your 401(k)?
For thousands of Americans, a 401(k) plan is the only real connection they have to the stock market. Some people have hundreds of thousands – or even millions – of hard-earned dollars invested in a 401(k) and still understand very little about how the plan works. Financial advisors often recommend investing as much money as possible in 401(k) plans because of the many investment advantages they provide. However, investors need to understand what their 401(k) actually is and how it works to unlock its full power. Here are seven things you need to know about your 401(k).
401(k) plans are tax havens.
Most of the biggest financial advantages of 401(k) plans are related to the tax advantages they provide. Income taxes take a huge bite out of career earnings, but 401(k) contributions are tax-deferred, meaning investors don't pay taxes on their invested earnings until they withdraw them from the 401(k) account. There are two benefits to this tax-deferred structure. First, Americans can earn capital gains on that income over time prior to paying taxes on it. Second, waiting to pay taxes on income until after retirement typically ensures that income will be taxed at a lower rate.
Annual contributions are limited.
Americans younger than 50 are only allowed to contribute $18,500 per year in a 401(k) plan. However, that annual contribution limit is raised to $24,500 after age 50. The IRS periodically adjusts these limits to adjust for inflation, so it's important to keep an eye on any changes. Both limits were just raised by $500 in 2018. This year, Americans who wish to max out their $18,500 annual contribution will need to set aside roughly $1,541 per month, or $356 per week, of their pretax income.
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Employer matches are free money.
Many companies incentivize employees to contribute to their 401(k) plans by offering contribution matching plans. Employers typically match a certain portion of an employee's total 401(k) contribution up to a percentage of his or her total income. For example, a company may match 100 percent of contributions up to 3 percent of annual income. In that scenario, a person earning $50,000 per year who contributes $1,500 annually to a 401(k) would get an additional $1,500 from his or her company as well. There's essentially no difference between taking full advantage of that matching plan and getting a $1,500 pay raise.
Your investment options are flexible.
Employers typically offer employees at least a handful of different 401(k) investment plans that have different risk-reward balances and a variety of investment strategies. While 401(k) plans may not offer the same type of flexibility as an individual trading account, choosing the appropriate plan can have a meaningful impact on the type of long-term returns investors get from their 401(k)s. Identifying the subtle differences in allocation and balancing may seem unimportant, complicated and boring, but understanding these differences and choosing the best plan for your personal retirement goals is critical.
401(k) plans aren't free.
Unfortunately, 401(k) plans are subject to a long list of potential fees, some of which are less obvious than others. On the surface, the funds you hold in your 401(k) account all likely charge individual fees, called expense ratios, that cover the administrative costs of managing each fund. Expense ratios are typically less than 1 percent annually. On top of the fees charged by individual funds, 401(k) plans often have individual service fees for optional features, such as the ability to borrow against the balance in your account, and plan-specific administrative fees for record keeping, legal services, accounting and other costs.
There are specific rules for withdrawals.
In order to access your 401(k) savings without penalty, you need to understand the rules for withdrawal. Anyone age 59.5 or older can withdraw from a 401(k) account without penalty. Starting at age 70.5, investors are required to start taking annual 401(k) distributions whether they want to or not. There are other hardship circumstances that allow for penalty-free 401(k) withdrawals prior to age 59.5 as well. In certain circumstances, Americans can withdraw 401(k) savings to pay for medical expenses, purchase a home, pay for college tuition, prevent eviction, cover funeral expenses or repair damages to a home.
Your 401(k) can follow you from job to job.
Just because you leave the job where you started a 401(k) doesn't necessarily mean you must cash out. Employees can typically choose to keep their plan open even after they leave a company. They can also choose to roll their 401(k) into an individual retirement account or a 401(k) provided by a new employer. They can also choose to receive a lump-sum payment as well. When rolling a 401(k) balance into a new retirement account, it's critical to properly make a direct transfer to avoid paying taxes on your balance.
Copyright 2017 U.S. News & World Report