7 Things to Know About Your 401(k)
If you have a 401(k), you’ve probably heard that you should contribute at least enough to this retirement plan to get the employer match. That’s good advice, because a match is like free money waiting for you to claim it—and you don’t want to leave that on the table!
But what else should you know about your 401(k)? We suggest reading over this list of 7 must-know facts about your retirement plan so you can get the most out of it.
1. Your 401(k) Can Help You Lower Your Taxable Income
Money you contribute to your 401(k) is considered “pretax,” meaning it’s not counted as part of your taxable income in the year you earn it and send it to your retirement account. Contributing your plan can help you pay less in taxes now—and help you build up your nest egg for the future.
Even better? The earnings on your invested money can grow tax-free. This allows you to keep more money in your account and working for your over time.
That doesn’t mean you avoid taxes forever; you will need to eventually pay taxes on the money you withdraw in retirement, but this is a good deal for most people. During your working years, you’ll likely be in a higher tax bracket than you will be in retirement. By deferring your tax burden, you can pay less today (and potentially use that savings to contribute more to your investments.)
2. A 401(k) Is Not a Savings Account. It’s an Investment!
Usually when we talk about 401(k)s, we say things like “I’m saving for retirement in my 401(k)” or “I save money in my 401(k).” There’s nothing wrong with saying this—as long as you understand that there is a difference between saving and investing.
Your 401(k) is an investment account. You contribute cash to the account, but you then invest that cash into various assets or securities. Because it’s a retirement account, this is most likely something like a target date fund or other index fund or mutual fund.
Make sure that you do allocate your contributions to some kind of investment within your 401(k). That’s the only way to earn a significant return on your money, and to take advantage of the power of compounding returns over time.
3. You Can Take Your 401(k)s with You When You Change Jobs (and You Probably Should)
You’ve probably had (way more) than just one job in your career if you’re in your 20s or 30s. And if you took advantage of the 401(k) plans that each employer offered you, then you might have multiple retirement accounts trailing after you every time you switch up your job situation.
Don’t just leave those 401(k)s behind! You can either roll them over into your current 401(k) plan, or you can roll over your old retirement plans into an individual retirement account (IRA) that you own and control.
The best option for you will depend on the specifics of your situation, but in general, rolling old plans into your current 401(k) makes sense if:
You feel like you’ll be in your current position for a long time.
Your current 401(k) offers a good fund selection and comes with low expenses.
Rolling old 401(k)s into an IRA, on the other hand, could make sense if:
You want full control over your retirement dollars.
You want more options for what you can invest in.
Your own IRA costs less to invest in than your existing 401(k).
If you’re unsure of what to do, you might want to talk to a fee-only financial planner (preferably one that’s also a CFP and a fiduciary) to help you sort through the options.
4. Your Contributions May Take Time to Vest
All this being said, before you enroll in any 401(k) plan, you should check to see if there are any rules or limitations around the account. Specifically, you might want to look to see if your employer requires you to stay at the company for a certain length of time before you fully own the match they provide.
This is usually known as a vesting period. If, for example, your employer match requires 3 years before it “vests,” that means any money your employer puts into your plan is subject to be taken back unless you stay with the company for at least 3 years.
Your own contributions are always yours; vesting periods usually apply to what your employer provides. Just because your plan comes with a vesting period doesn’t mean you shouldn’t contribute—but it’s something important to know and understand before you get started.
5. Taking Money Out of Your 401(k) Can Cost You (in More Ways Than One)
Your 401(k) money is meant to be for retirement, which is why you get some really nice tax breaks for using this account. But if you pull cash out before you reach 59 and ½, you’ll likely be penalized.
Normally, early withdrawals from 401(k)s will come with a 10% penalty. On top of that, you’ll have to pay income tax on the money you took out of the account. And as if those two blows weren’t enough, you also incur an opportunity cost: if you pull money out of investments, it means you lose an opportunity for it to compound over time.
You may also risk taking money out in a down market, which means you realize investment losses. Recessions or market downturns aren’t a bad thing when you have a long time to invest, because your money has a chance to grow again when the market bounces back and starts expanding again. Any red you may see in your portfolio is an unrealized loss.
But if you take your money out of your investments while markets are down, you take that unrealized loss and turn it into a very real one. Add that in with the penalties you accrue by taking money out of your 401(k) early, and you’ll find making withdrawals before retirement is rarely worth it.
6. You Might Be Able to Make “Roth” Contributions
The traditional 401(k) plan allows you to contribute pretax income to your account. That means you don’t pay taxes on those contributions, but you will pay taxes when you withdraw the money in retirement.
But some plans come with what’s called a Roth option, and this works in the opposite way: if you make contributions to the Roth part of your 401(k), then you will pay taxes on that money in the year you contribute -- but when you withdraw from the account in retirement, that money is tax-free.
You might want to contribute to both your traditional and Roth portions of your 401(k) if you can. Doing so allows you to spread your tax liability more evenly now and in the future.
7. Fees Matter
Before you invest any of your cash into a fund within your 401(k), you need to check the fund’s expense ratio. This is the fee you pay to invest there—and high fees can seriously hurt your ability to grow wealth over time.
The lower the expense ratio, the less you’ll pay to invest in that particular fund. An average expense ratio for mutual funds is about 0.5%, but you can find index funds that cost even less. Paying 1% or more is generally far too expensive; you should look for cheaper options to keep more of your hard-earned money in your pocket.
Kali Roberge is a personal finance writer who contributes to JUGs to explain how freelancers and entrepreneurs can make the most of their money, and writes about mindful living through intentional spending through her email series, LETTERS. You can find her @KaliRoberge