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If you’re a member of the modern workforce, you likely have access to a 401(k). A 401(k) is a retirement savings vehicle sponsored by your employer. Through your 401(k), you’re able to contribute funds and invest them according to your risk tolerance and retirement timeline. The goal is to grow a sizable retirement nest egg for yourself over the course of your career by leveraging compound interest as you continue to contribute to your 401(k).
As a financial planner, one thing I’m always surprised by is how many people have access to a 401(k), but don’t necessarily know what to expect from their plan (or how to use it). In fact, many people contribute on auto-pilot without updating their investing preferences, if they contribute at all.
It’s time to change that. Let’s go over ten unique things about your 401(k) that you may not have known before – and how they benefit you and your retirement savings.
#1: Your 401(k) is Directly Connected to Your Employer
The contributions you make to your 401(k) are 100% yours, but the account itself is technically sponsored by your employer. To contribute to a traditional 401(k), you’ll need to find out if your employer offers a plan, and set one up through them. Your 401(k) is funded by contributions deducted from your paycheck, which can be a great way to automate your retirement savings.
#2: You’ll Want to “Roll Over” your 401(k) If You Change Jobs
Because your 401(k) is connected to your employer, you’ll want to roll your 401(k) over when you change jobs. Usually, you have a few options for how you want to use your old 401(k) when making this transition:
- You can leave your 401(k) alone, stop contributing, and let the funds continue to grow tax-deferred.
- You can “roll” your 401(k) to your new employer’s 401(k) plan and continue to contribute there.
- You can “roll” your 401(k) to a Traditional or Roth IRA. If you choose to roll it to a Roth IRA, you will have to pay income tax on the funds that you roll over. This will give you greater flexibility around your investment options.
#3: There are Contribution Limits
In 2020, you can contribute up to $19,500 to your 401(k). If you’re 50 or older, you can increase that to an annual total of $26,000 by leveraging the “catch up” contribution limit. Usually, you contribute to your workplace 401(k) by allocating a percentage of your paycheck.
If you want to max out contributions this year, make sure you have your percentage contribution dialed in so that you don’t go over the limit. If you do, you’ll be subject to a 6% excise tax.
#4: Anyone Can Participate
There is no income minimum for opening and contributing to a 401(k) through your employer. Some employers even offer their 401(k) to part-time employees. In other words, it doesn’t matter if you’re a brand new employee or if you’ve been there for 10+ years – you’ll be able to leverage your 401(k) to save for retirement no matter what!
There’s also no income maximum for contributing to a traditional 401(k). Unlike similar Roth accounts, your income has no bearing on how much you’re allowed to contribute according to the IRS.
#5: You Have to Start Withdrawals at Age 72
Although the funds in your 401(k) are yours to use as you please once you hit retirement, you can’t just let them sit in your account forever. There are specific withdrawal requirements you have to meet as you age.
According to the new SECURE Act, retirees must start taking Required Minimum Distributions (RMDs) from their 401(k) by age 72, which is up from the original age limit of 70½. This new withdrawal requirement gives retirees more flexibility when creating a retirement income strategy. It’s especially useful as more and more pre-retirees are choosing to work well into their 60s or 70s (and want to continue contributing to their 401(k)s, not withdrawing from them).
#6: You Can’t Withdraw (Without Penalties) Until Age 59½
Just like there are specific rules about when you have to start withdrawing from your 401(k), there are also specific rules around what age you’re allowed to start taking withdrawals. If you take a withdrawal from your 401(k) before age 59½, you’re subject to regular income tax on the funds you withdraw and a 10% penalty – ouch.
Of course, there are a few exceptions to this rule. If your 401(k) is set up through the employer you’re retiring from, you may be able to start taking withdrawals at age 55. There are also rules in place that allow you to leverage your 401(k) for disability and specific medical expenses. These special circumstances are referred to as “hardship withdrawals” and they help you sidestep the 10% early withdrawal penalty if you use them for:
- Medical expenses exceeding 7.5% of your annual gross income.
- Permanent disability.
- Substantial equal periodic payments.
- Separation of service.
Some plans also allow you to take out a loan against your 401(k). You pay the loan back through additional payroll deductions. However, as appealing as this may sound, you need to think carefully before pursuing a 401(k) loan. If you’re unable to pay the loan back before you change jobs, or before age 59½, you’ll likely owe income taxes and the 10% early withdrawal penalty on the funds.
Additionally, 401(k) loans essentially “rob” your retirement to help you achieve a short-term financial goal. The money you take out of your 401(k) now loses any potential capital gains or growth that could be achieved through investing.
#7: You Can Contribute to a Roth or a Traditional 401(k)
There are two different types of 401(k)s – Traditional and Roth. Usually, employees choose to contribute to a traditional 401(k) through their employer. However, many employers offer a Roth 401(k), as well. This type of account is funded with contributions that have already been taxed.
As a result, the funds grow tax-free until you retire, at which time you can take withdrawals without paying income taxes. It’s often wise to diversify the type of taxable (or non-taxable) accounts you have to pull a retirement income from, so if a Roth 401(k) is available through your employer, you may want to start contributing there, as well.
#8: There Are Fees Associated With Your 401(k)
As is the case with many investment accounts, your 401(k) will be subject to a set of fees for maintaining the account. Your 401(k) fees will cover the setup of your account and ongoing management. Fund fees, on the other hand, are fees directly related to the investments within your account.
The company that holds your plan charges these to run your account on an ongoing basis. It’s important to familiarize yourself with the fees you’ll be paying because they can add up depending on the investments in your portfolio!
#9: Your Employer May Have a Matching Policy
Many employers have a standard contribution matching policy for their employees who fund a company 401(k). This type of incentive helps you to grow your retirement nest egg on your employer’s dime! Contribution matching may range anywhere from 3-6% of your salary.
If you aren’t currently contributing up to your employer’s match, you should adjust accordingly to take advantage of this perk. If you don’t, you’re essentially leaving free money on the table – which is never a wise financial move.
#10: You Get to Select Your Own Investments
In most 401(k) plans, you have the flexibility to select your investments. Some plans have more availability than others, but you should be able to (at a minimum) select a risk tolerance level based on your retirement horizon and set your plan up accordingly. When you are a long way from retirement, your risk tolerance will be higher than when you are a few years out.
That’s because the more time you have before retirement, the more time you have to recover from any dips in your portfolio that happen as a result of higher-risk funds. However, you also have more time to take advantage of potentially higher returns from those same higher-risk investments. As you get closer to retirement, you want to minimize your risk to maintain and protect your nest egg.