How much do you know about your 401(k) plan? Often, even though employer-sponsored retirement plans may make up the bulk of employees’ retirement savings, participants understand less than they need to about how this savings vehicle works. Here’s a primer covering 10 crucial facts:
1. You benefit from tax-favored treatment. For starters, contributions to your account are made on a pre-tax basis. For example, if you earn $100,000 a year and elect to defer $10,000 to the plan, you’re taxed on only $90,000. What’s more, the money you’ve contributed will grow, without taxes, inside the plan until you withdraw it.
2. There’s an annual limit on how much you can contribute. The normal ceiling, adjusted each year for inflation, remains $17,500 for 2014. Plus, you can sock away an extra $5,500 a year (also adjusted for inflation) if you’re age 50 or older. That adds up to as much as $23,000 for 2014. However, other tax law limits could affect your overall contribution.
3. Your employer may choose to match part of your contribution. Obviously, you’re reducing your take-home pay when you defer part of your salary, but companies often help offset that deduction. You might get a matching contribution with your employer kicking in, say, 50 cents for each dollar you put in for up to 6% of your pay. If you earn $100,000 and contribute $10,000 annually, that could add an extra $3,000 to your account each year (half of the first 6% of salary that you contribute).
4. Participation may be automatic. Increasingly, employers use an automatic enrollment feature that adds you to its 401(k) plan unless you opt not to participate. That encourages you to save for retirement and helps companies avoid penalties that may be applied if too few lower-paid employees sign up. The initial default-deferred amount might be 3% of your salary, and some companies now add an “escalator clause” that automatically increases later deferrals.
5. You have a wide array of investment choices. How should you invest the funds in your 401(k)? You’ll normally be able to choose from among a dozen or more standard options that may include several “target date” mutual funds, which adjust their allocations as you get nearer to retirement. If you don’t make your own selections, a default option may be triggered.
6. You’re penalized if you take out money early. You’ll generally have to pay a 10% penalty on withdrawals you make prior to age 59½, unless a special tax law exception applies. That’s in addition to the regular income tax that applies to all withdrawals.
7. You’re penalized if you take out money too late. You must begin taking “required minimum distributions” (RMDs) from your 401(k), based on life expectancy tables, in the year after the year in which you turn age 70½. The penalty for not doing that is stiff—50% of the amount you should have taken. But you may be able to postpone RMDs if you’re still working full-time and you own less than 5% of your employer.
8. You may be able to “Rothify.” Some company plans now offer the opportunity to use a Roth 401(k). Just as with a Roth IRA, you make contributions on an after-tax basis, but withdrawals during retirement normally won’t be taxed. At companies that offer this option, you can divide your contribution between regular and Roth accounts as you choose.
9. You have several options when you leave the company. When you leave your job, you can take a lump-sum payout from your account—which will trigger income tax and a penalty if you’re under 59½—leave the money where it is, or roll it over to another company’s plan or to an IRA. With a rollover, you won’t owe any tax as long as the transfer is completed within 60 days of leaving. To avoid 10% withholding, make a trustee-to-trustee rollover.
10. You’ll owe fees that may vary widely from plan to plan. If your 401(k) charges high administrative or investment management fees, those could siphon off a significant portion of your investment earnings. The lower the “expense ratio” of the mutual funds you select, the less you’ll pay in fees. Index funds that passively track market benchmarks can be especially inexpensive.
Make sure you have all of the information you need to make smart choices about your account.