If you are a member of the modern workforce, you probably have access to a 401 (k). A 401 (k) is a pension vehicle sponsored by your employer. With your 401 (k) you can bring in funds and invest them according to your risk tolerance and your retirement schedule. The goal is to grow a significant nest egg over the course of your career by using compound interest while you continue to contribute to your 401 (k).
As a financial planner, I’m always amazed at how many people have access to a 401 (k), but don’t necessarily know what to expect (or how to use it) from a plan. In fact, many people contribute to the autopilot without updating their investment preferences, if they do at all.
It’s time to change that. Let’s go through ten unique things about your 401 (k) that you may not have known before – and how they can 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 need to find out if your employer offers a plan and set one up through it. Your 401 (k) is funded by contributions that are deducted from your paycheck. This can be an excellent way to automate your retirement savings.
# 2: When you change jobs, you want to extend your 401 (k)
Since your 401 (k) is connected to your employer, you want to extend your 401 (k) when you change jobs. Usually you have a few options on how you want to use your old 401 (k) in this transition:
- You can leave your 401 (k) alone, no longer make any contributions and continue to let the funds grow deferred tax.
- You can “roll” your 401 (k) into your new employer’s 401 (k) plan and continue to make a contribution there.
- You can “roll” your 401 (k) to a traditional or Roth IRA. If you transfer it to a Roth IRA, you will have to pay income tax on the funds you transfer. This gives you more flexibility in your investment options.
# 3: There are contribution limits
In 2020 you can contribute up to $ 19,500 for your 401 (k). If you’re 50 years of age or older, you can increase this to a total of $ 26,000 a year by using the “catch up” premium limit. Typically, you contribute 401 (k) to your workplace by allocating a percentage of your paycheck.
If you want to make maximum use of the contributions this year, make sure that your percentage contribution is selected so that you do not exceed the limit. In this case an excise tax of 6% will be charged.
# 4: Everyone can participate
There is no minimum income for opening and contributing to a 401 (k) through your employer. Some employers even offer their 401 (k) part-time workers. In other words, it doesn’t matter if you are a brand new employee or have been there for more than 10 years – you can use your 401 (k) to save for retirement no matter what!
There is also no maximum income for contributing to a traditional 401 (k). Unlike similar Roth accounts, your income doesn’t affect how much you can contribute, according to the IRS.
# 5: You have to start taking off at 72 years of age
Although the credit in your 401 (k) is available to you as you wish, you cannot simply leave it in your account forever. There are certain withdrawal requirements that you have to meet as you age.
The new SECURE Act requires retirees from the age of 72 to take the required minimum payout (RMDs) from their 401 (k) is from the original age limit of 70½. This new payout obligation gives pensioners more flexibility in creating a retirement income strategy. This is particularly useful as more and more early retirees choose to continue working until the 1960s or 1970s (and want to continue contributing to their 401 (k) without withdrawing from them).
# 6: You cannot withdraw (without penalties) up to the age of 59½ years
Just like there are certain rules about when you should have to When you retire from your 401 (k), there are also special rules for your age allowed to Make withdrawals. If you make a payment from your 401 (k) before the age of 59, you are subject to regular income tax on the amounts you withdraw and a 10% penalty – ouch.
Of course there are some exceptions to this rule. If your 401 (k) is set up through the employer you are retiring from, you may be able to withdraw at 55 years of age. There are also rules that allow you to use your 401 (k) for disabilities and certain medical expenses. These special circumstances are called “HardshipsAnd they help you get around the 10% early withdrawal penalty if you use it for:
- Medical expenses over 7.5% of your gross annual income.
- Permanent disability.
- Essentially same regular payments.
- Separation of service.
With some plans, you can also take out a loan against your 401 (k). You repay the loan through additional wage deductions. As appealing as this may sound, you need to think carefully before taking out a 401 (k) loan. If you are unable to repay the loan before you change jobs or before you are 59½ years old, you will likely have to pay income taxes and the 10% early withdrawal penalty for the funds.
In addition, 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 investments could generate.
# 7: You can contribute to a Roth or a traditional 401 (k)
There are two different types of 401 (k) – Traditional and Roth. Typically, employees choose to contribute to a traditional 401 (k) through their employer. However, many employers also offer a Roth 401 (k). This type of account is funded with contributions that have already been taxed.
As a result, funds grow tax-free until you retire. At this point, you can make withdrawals without paying income taxes. It is often advisable to diversify the types of taxable (or non-taxable) accounts from which you need to draw a retirement income. So if a Roth 401 (k) is available through your employer, you may want to contribute there too.
# 8: There are charges associated with your 401 (k).
As with many investment accounts, your 401 (k) will incur account management fees. Your 401 (k) fees cover account setup and ongoing administration. Fund fees, however, are fees that are directly related to the investments in your account.
The company holding your plan will calculate this to keep your account running. It is important to familiarize yourself with the fees you will be paying as these 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 401 (k) company. This type of incentive will help you to raise your nest egg for your employer’s penny! The contribution comparison can be between 3 and 6% of your salary.
If you are currently not contributing to your employer’s match, you should adjust accordingly to take advantage of this. If you don’t, you’re essentially leaving free money on the table – which is never a smart financial move.
# 10: You can choose your own investments
Most 401 (k) plans give you the flexibility to choose your investments. Some plans have higher availability than others, but you should be able to (at least) choose a risk tolerance level based on your retirement horizon and set up your plan accordingly. If you are far from retirement, your risk tolerance is higher than after a few years.
This is because the more time you have before retirement, the more time you will have to recover from slumps in your portfolio that occur due to higher risk funds. However, you also have more time to take advantage of potentially higher returns from the same riskier assets. As you approach retirement, you want to minimize your risk of receiving and protecting your nest egg.
Do you have any questions?
Do you have any questions about your 401 (k)? Contact us today! We are here to help you organize a retirement savings strategy that fits your individual goals.
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