401k: Understanding the Ins and Outs of the Most Popular Retirement Tool

Whether you’ve just started a new job, or you’ve been at one for years, odds are that your employer has given you the option to participate in an employer-sponsored 401(k) retirement plan (401k).  The 401(k) plan is one of the most popular retirement tools for working individuals.  Despite its popularity, surveys have shown that many people do not fully understand their 401(k).  This can inhibit their ability to maximize the potential of their 401(k).  Here are some core components you should be aware of regarding your 401(k):

401k – How do I enroll?

Many large employers will automatically enroll employees in the company’s 401(k).  If you are not automatically enrolled, you should be able to reach out to your company’s human resources department and complete the enrollment process.  Some retirement plans, especially those sponsored by smaller companies, require you to work a certain amount of time before you are eligible to participate.

How much can I contribute to a 401k?

What’s noteworthy about a 401(k) and why it is such a powerful retirement savings tool is the amount you can contribute.  For 2020, the maximum contribution is $19,500.  If you are 50 or older, the maximum contribution is $26,000.  The $6,500 difference is known as the catch-up contribution, offering those nearing retirement the ability to save more.  You have the ability to save much more for retirement in a 401(k) compared to an individual retirement account (“IRA”).  The maximum contribution limits for IRAs for 2020 are $6,000 for those under the age of 50 and $7,000 if you are 50 or older.

An additional benefit of a 401(k) is that, as long as you’re working, there’s no age restriction on contributions, similar to a Roth IRA.  You can no longer contribute to a traditional IRA in the year you turn 70 ½.

How do 401k contributions impact my taxes?

Your 401(k) may offer you the option to contribute to either a traditional 401(k) or a Roth 401(k).  These options have different tax implications.  Traditional 401(k) contributions are deducted from your paycheck on a pre-tax basis which will reduce your taxable income for the year.  Money invested in your traditional 401(k) grows on a tax-deferred basis meaning that investment income (interest, dividends, and capital gains) will not be subject to tax in the year earned.  The government won’t collect taxes on this account until you make withdrawals, at which point the annual withdrawals will be subject to your ordinary income tax rate.

With a Roth 401(k), contributions come from your salary after-tax meaning that they are taxed in the year you make the contribution.  Like a traditional 401(k), the money invested in a Roth 401(k) grows on a tax-deferred basis.  However, withdrawals from a Roth 401(k), if done correctly, are tax-free.  If you’re just starting out in your career and you’re in a lower tax bracket than you’ll be later in life, it makes sense to contribute to a Roth with after-tax money and pay tax at a lower rate now.

If your employer offers both a traditional 401(k) and a Roth 401(k), talking to a financial advisor or tax planner is a great way to assist you in determining which option is best for you.

Does my company offer employer matching contributions?

It’s important to know whether your employer will make a matching contribution to your 401(k).  Some employers may match dollar for dollar; others may give you a percentage of your contributions (say, 75 cents for each dollar you put in) up to certain amounts.  Essentially, any employer contribution is free money.  Contributions made by your employer do not count toward your maximum annual contribution limits.  The employer match sometimes comes with stipulations that you must work at the company for a certain number of months or years before the match vests, which is when the employer money is yours to keep.  The vesting schedule typically is gradual – meaning a certain percentage of the employer match becomes yours after a set time (say, 40 percent vested after two years on the job) and then becomes 100% yours at a later date.

What are my investment choices and how should I invest?

Some 401(k)’s have only a few investment options, while others can have hundreds.  One of the potential downsides of a 401(k) is that your investment options may be limited.  Employers often contract their 401(k)s with a single investment firm, potentially leaving you to choose from a limited number of mutual fund options.

Any investment choice should be based on your age and your risk tolerance.  The younger you are, the riskier you can afford to be.  That is, if you can stomach market swings, you’re generally better off in stocks which historically have returned more than bonds over time.  Some 401(k)s offer the option to invest in target-date funds. These funds’ assets automatically shift to more conservative investments as retirement nears.  A 2050 fund would invest aggressively in more volatile assets such as stocks, but would convert to safer bonds and fixed income by 2050.

What penalties should I be aware of?

The first eligible age to begin making withdrawals from a 401(k) is 59 ½.  If you take money from your 401(k) before then, you will likely be subject to a 10% early withdrawal penalty in addition to paying ordinary income tax on the money withdrawn.  One of the worst mistakes people can make when they leave their job is to withdraw their 401(k) balance instead of rolling it over to an IRA.  There are some exceptions to the general rule that allow you to avoid the 10% penalty and withdraw your money before turning age 59 ½.  Examples include becoming totally and permanently disabled or paying unreimbursed medical expenses exceeding 10% of your adjusted gross income.  In most cases, withdrawing your money early will require paying a 10% penalty in addition to any ordinary income taxes.

What happens when I begin taking distributions from my 401k?

As mentioned before, you can begin making withdrawals without penalty after turning 59 ½.  You are required to take annual distributions from your traditional 401(k) and pay the related tax once you reach age 70 ½ or you could face a penalty.

Understanding the ins and outs of your 401k increases your chances of maximizing your return potential and setting yourself up for a comfortable retirement.