10 Things You Must Know About 401(k)s
Slide Show

10 Things You Must Know About 401(k)s

Thinkstock

Advertisement
Advertisement

When you start a new job, one of the first decisions you'll likely make is whether to participate in the company's 401(k) plan. The earlier you start saving in a 401(k), the better. But no matter how old you are, it's never too late to contribute more to your 401(k) and bolster your future retirement security. Here are ten things you need to know about these company retirement plans.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 2 of 11

You Will Benefit From Tax Breaks

Thinkstock

Advertisement
Advertisement

With its name derived from the tax code, the 401(k) is an employer-based retirement savings account known as a defined-contribution plan. You contribute pretax money from your salary, which lowers your taxable income and helps you cut your tax bill now. For instance, if you make $4,000 a month and save $500 a month in your 401(k), only $3,500 of your monthly earnings will be subject to tax.

Plus, while inside the account, the money grows free from taxes, which can boost your savings. Say you saved $6,000 a year for 40 years and the money grew at 6% annually. If that money was taxed along the way at 25%, you'd have $642,182 after 40 years. With the tax deferral of the 401(k), the account balance grows to $928,572.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 3 of 11

You May Already Be Enrolled

Thinkstock

Advertisement
Advertisement

An increasing number of companies are enrolling employees automatically into their 401(k) plans, allowing workers to opt out if they choose. Often the initial contribution rate will start at 3% of pay. According to research by the Plan Sponsor Council of America, nearly 46% of companies use auto enrollment and about 55% of those companies also use an "auto escalation" feature. This feature gradually raises the default contribution rate over time. Again, workers may opt out, or they may choose to set a higher (or lower) rate of savings. But beware: Employees who rely solely on the default rates may not end up with a sufficient nest egg, as most experts recommend saving 12% to 15% of pay a year.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 4 of 11

There's a Limit to How Much You Can Stash

Thinkstock

Advertisement
Advertisement

The IRS sets an annual limit on how much money you can set aside in a 401(k). That limit can change because it is adjusted for inflation. For 2014, you can put away $17,500. Those age 50 or older by year-end can contribute an extra $5,500. Check out the Financial Industry Regulatory Authority's 401(k) Save the Max Calculator, which will tell you how much you need to save each pay period to max out your annual contribution to your 401(k). If you cannot afford to contribute the maximum, try to contribute at least enough to take full advantage of an employer match (if your company offers one).

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 5 of 11

Your Company May Give You Free Money

Thinkstock

Advertisement
Advertisement

Most employers will help you save in your 401(k). Many companies will match an employee's contribution up to a certain percentage, perhaps 50 cents for every dollar you contribute up to 6% of your pay. Be clear on what the company's formula is. "That's part of compensation," says Andrew McIlhenny, an executive vice-president of Firstrust Financial Resources.

Some companies will provide contributions to employees' accounts, regardless of whether employees contribute their own money. And some employers may provide the match in company stock. Whichever way the company helps you save, ask whether there is a vesting schedule for that employer-provided money. You may have to work for the company for a certain amount of time before that money becomes 100% yours.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 6 of 11

Fees Will Take a Bite

Thinkstock

Advertisement
Advertisement

Unfortunately, retirement saving doesn't come free. In fact, it can be costly: According to "The Retirement Savings Drain," a research report by Robert Hiltonsmith, of the nonpartisan public policy research and advocacy organization Dēmos, fees could eat up 30% of a 401(k) portfolio by the time you reach retirement.

Pay attention to each fund's expense ratio, which is a measure of a fund's operating expenses expressed as an annual percentage. Look at your 401(k) plan's Web site to find a fund's expense ratio, or check out Morningstar.com; the lower the expense ratio, the less you'll pay to invest. A total expense ratio of 1% or less is reasonable. The good news is that your plan may give you access to lower-cost institutional shares, which are cheaper than different share classes of the same investment bought through an IRA. The average expense ratio for stock funds in 401(k)s was 0.63% in 2012, according to the Investment Company Institute. One way to cut costs: Look to see whether your plan offers index funds, which tend to be cheaper than actively managed funds.

On top of investment fees, expect to pay administrative fees, too. Ask your benefits manager for details on your plan's costs. The federal government issued a new rule that requires companies to do a better job of disclosing all the fees you pay for your 401(k). Also, check BrightScope.com, which rates 401(k) plans. The site can show you how your 401(k) stacks up against other companies' plans. And if your plan isn't competitive with other company plans, start asking your company's benefits manager about ways to improve the plan.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 7 of 11

You Have an Investment Menu

Thinkstock

Advertisement
Advertisement

In a 401(k), your employer will select the investment choices available to employees. You, as the employee, can then decide how to allocate your contribution among those available options. If you don't make a selection for your contribution, your money will go to a default choice, likely a money-market fund or a target-date fund.

On average, 401(k)s offer 19 funds to choose from, according to the Plan Sponsor Council of America. Most plans will offer actively managed domestic and international stock funds and domestic bond funds, plus a money-market fund. Many plans also offer low-cost index funds. (Check to see if your plan offers any of The Best Funds for Your 401(k).)

Also common on the 401(k) menu: target-date funds, which nearly 70% of plans offer. Over time, this breed of fund typically shifts from a stock-heavy portfolio to a more conservative, bond-heavy portfolio by its target date.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 8 of 11

You May Have a Roth Option

Istockphoto

Advertisement
Advertisement

Another choice to consider: a Roth 401(k). Not all plans offer the Roth option, but if yours does, you are allowed to put in after-tax money in exchange for tax-free growth and tax-free withdrawals in the future.

You can choose to divide your annual contribution between the traditional 401(k) and the Roth 401(k). Any employer match will go into a traditional 401(k).

As of 2013, more workers gained the opportunity to convert a traditional 401(k) to a Roth 401(k). You'll have to pay tax based on the investments' value at the time of the in-plan conversion. But beware: Unlike IRA Roth conversions, you can't undo a 401(k) Roth conversion -- the decision is irrevocable. (Learn more in Reduce the Risks of the New Tax Scenario.)

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 9 of 11

There Are Ways to Access the Money Early

Thinkstock

Advertisement
Advertisement

Money you stash in a 401(k) isn't meant to be touched until retirement, and any money withdrawn could be subject to a 10% early-withdrawal penalty. But if you leave a job as early as age 55, you can tap the 401(k) penalty-free (IRAs can’t be tapped penalty-free until age 59 1/2).

Company 401(k)s also generally allow participants to borrow from their accounts. You may have to pay a fee to take a loan. Plus, you'll be charged interest on the amount you take out. But you'll basically be paying interest to yourself because the money goes into the account. Watch out if you have outstanding loans when you leave a company -- the loans will have to be repaid within 60 to 90 days. If not, the amount of the loan will be considered a taxable distribution.

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 10 of 11

You Can Roll Over the Account

Thinkstock

Advertisement
Advertisement

Workers generally have four options for their 401(k) when they leave a company: You can take a lump-sum distribution; you can leave the money in the 401(k); you can roll the money into an IRA; or, if you are going to a new employer, you may be able to roll the money to the new employer's 401(k). (Note: Those with balances of less than $5,000 may not get the option to keep their money in their old plan.)

It's usually best to keep the money in a tax shelter, so it can continue to grow tax-deferred. Whether you roll the money into an IRA or a new 401(k), be sure to ask for a direct transfer from one account to the other. If the company cuts you a check, it will have to withhold 20% for taxes. And whatever money isn't back in a retirement account within 60 days will become taxable. So if you don't want that 20% to be considered a taxable distribution, you'll have to use other assets to make up the difference. (Once you file your tax return for the year, you'll get that withholding back.)

Advertisement
Advertisement
Advertisement

10 Things You Must Know About 401(k)s | Slide 11 of 11

You Eventually Must Take the Money

Thinkstock

Advertisement
Advertisement

Uncle Sam won't let you keep money in the 401(k) tax shelter forever. As with IRAs, 401(k)s have required minimum distributions. At age 70 1/2, you will have to calculate an RMD for each old 401(k) you own. Once you've determined the RMD, the money must then be withdrawn separately from each 401(k). Note that unlike Roth IRAs, Roth 401(k)s do have mandatory distributions starting at age 70 1/2.

If you hit that magic age and are still working, and you don't own 5% or more of the company, you don't have to take an RMD from your current employer's 401(k). And if you want to hold off on RMDs from old 401(k)s and IRAs, you could consider rolling all those assets into your current employer's 401(k) plan.

Advertisement
Advertisement