When it comes to retirement planning in the United States for employees of private companies, 401(k)’s are extremely common (north of 60 million active participants). Let’s cover four things that you should know about them!
1. Traditional vs. Roth
There is an important tax distinction to make in order to fully understand your 401(k). Similarly to Individual Retirement Accounts (IRA’s), they can be either Traditional or Roth investment vehicles.
With a Traditional 401(k), contributions are taken out of your paycheck before taxes are taken out. This is important for two reasons:
This funds in the account grow tax-deferred (more money to grow without taxes taken out = more growth)
You will, later on, owe taxes on this money
Now, with a Roth 401(k), contributions to the account are made after taxes have been paid. What’s great about that is that once you go to use the funds (provided you are over 59.5 years old and the funds have been in the account for at least 5 years), you will not pay any income taxes on distributions.
An important distinction between Roth 401(k)’s and Roth IRA’s (read more on those here) is that there are Required Minimum Distributions (RMD’s) from Roth 401(k)s. Once reaching the age of 72, Uncle Sam mandates that you take a certain amount in distributions from the account each year (the amount varies). I honestly have no idea at all why they do this for Roth 401(k)’s. The reason the government created RMD’s for Traditional accounts is to force a distribution so that they can receive their income taxes, which makes sense (for the government at least), but I digress.
If you are unsure which type of account you have, you should be able to see if you log on to the provider’s website. It also will show this information in the account statement. If neither of those things are easy for you to find, it isn’t too hard to find the phone number of the plan provider and give them a call!
2. These Are Employer Sponsored Plans
Your 401(k) is run through your employer. What that means is that if you leave your current job, you will have to make arrangements for the account.
Upon leaving, you have several options:
Roll into your new employer’s 401(k)
Roll into a traditional IRA
Withdraw the funds as cash (taxable and will almost certainly incur a penalty if you are under the age of 59.5)
Leave it where it is (will likely sit as uninvested cash, it can eventually become abandoned property and – depending on the state you live in – be turned over to the state
Personally, I feel that options one and two above make the most sense in almost all cases.
I always love to see breakdowns like the above. What bothers me is that many Americans rely solely on their 401(k) as retirement savings (outside of Social Security), and these numbers do not come close to allowing a comfortable retirement. We can do better!
3. There is No Income Limit
Starting in 2022, the maximum annual contribution you can make to your 401(k) is moving up from $19,500 to $20,500 (thanks inflation). If you are over the age of 50, you can make an additional, “catch up contribution” of $6,500 each year.
Unlike Individual Retirement Accounts (IRA’s), there are no income limits that would prevent you from contributing to your 401(k)!
A contribution to a Traditional 401(k) brings down your total taxable income in the year that you make it, and the tax deferred growth is what makes these accounts so popular.
One note, if you make a whole lot of money (like well into six figures), your employer match can be gradually brought down. This goes beyond the scope of this article, but this is a great read on the subject.
4. Your Investment Options Are Limited
One downside that 401(k)’s have in comparison to Individual Retirement Accounts is that the plan typically provides a very limited set of investment options.
It is extremely important that you do your research when selecting your investment mix in your 401(k). It is likely that the company who offers your plan has people available (either by phone or by meeting) that can discuss / further explain things, but the whole goal of me writing all of these articles is to arm you with the knowledge to understand what you are doing!
The first important thing that I like to check is the fees. It is likely that your 401(k) itself has fees (for tons of different things), but you can’t do much about that.
What you can control, however, are the expense ratios of the funds that you choose to invest in.
**Reminder that a 401(k) is NOT an investment, it is just an account. You actually have to make investments within the account**
While diversification is also very important here, I personally do my best to avoid funds that have an expense ratio above 0.5% whenever possible.
I made a video here breaking down how severely fees can impact your returns over time.
Generally, as far as investment choices, index funds are never a bad place to be. I wrote an in depth article here if you want to learn more about them!
Thank you so much for taking the time to read this article! Please do not hesitate to reach out to me with any questions, suggestions, or comments!