401(k) plans are a
big deal for American workers. How big? Well, consider that as of March 2018,
about 55 million employees and millions of former employees had more than
$5 trillion socked
away in 401(k)s, according to the Investment Company Institute. Indeed, income
from 401(k) accounts has been estimated to represent about 25% to 30% of
Americans' total retirement income.
Offering generous
contribution limits, matching funds from employers (in most cases), major tax
savings, and sometimes even profit-sharing contributions, a 401(k) can be hard
to beat. If you're not making the most of your 401(k), you may regret it down
the road. So, let's go over the critical 401(k) rules so you can maximize your
odds of having a comfortable, secure retirement.
Note: Much of the
following information and guidance also applies to 403(b) accounts, 457 plans,
and the U.S. government employee Thrift Savings Plan (TSP).
What is a 401(k)?
401(k) accounts are "defined
contribution" retirement accounts, named for a section of the Revenue Act
of 1978 in which they were introduced. The term "defined
contribution" refers to the fact that employees (and often their
employers, too) regularly contribute a fixed amount of money. That defined
contribution could be either a fixed dollar amount or a certain percentage of
the employee's paycheck. The end value of the account is uncertain, as it all
depends on how much time the money has to grow and how well the investments
perform.
By contrast,
pensions are "defined benefit" plans. Few people know exactly how
much goes into them, but employees have a good idea of how much the pension
will pay them in retirement benefits.
Of course,
there's more to a 401(k) account than just that -- its main benefit is that it
can save you a lot in taxes. As you'll learn below, contributing to a
traditional 401(k) annually can shave your tax bill each year, while a Roth
401(k) will let you avoid paying some potentially hefty tax bills in the
future. With both kinds of 401(k)s, the whole time your money is in your
account, it's growing without any taxation.
Who's eligible
for a 401(k)?
If you work for
a company that offers a 401(k) plan, you're probably eligible to participate in
it -- if not immediately, then soon. Unfortunately, many companies, especially
small ones, don't offer 401(k)s. As of 2012, while 75% of employers surveyed
with 1,000 or more employees offered 401(k) plans, only about 10% of those with
10 to 100 workers did so, according to a report from the Government
Accountability Office.
Note that if
you don't have a 401(k) plan available through work, you still have some
options. You can focus on making the most of IRAs, for one
thing, and you can always save and invest for retirement in a regular,
non-tax-advantaged account, too. Those who are self-employed might want to look
into SIMPLE or SEP IRAs, as well.
Defining 401(k) terms
Before we get into
the important 401(k) rules, here's a quick review of some key 401(k)-related
concepts:
Elective deferrals: These are the contributions you make to your 401(k). You elect to defer a fixed sum or
percentage of each paycheck to your 401(k), so your take-home pay is reduced
accordingly.
Employer match: While your elective deferrals will typically make up the majority of
your 401(k)'s value, there's a good chance you'll enjoy some matching funds,
too. That's when your employer adds some of its own money to your account
according to a formula. Matching formulas vary, but a common one is when a
company chips in 50% of contributions of up to 6% of your income. So if you
earn $100,000 and contribute $6,000, your employer will add another $3,000 to
your account. The average total company match was 4.7% as of 2016, per the
Vanguard Group.
Contribution limits: You may not be able to contribute as much as you want to your 401(k),
as the IRS imposes limits. For 2018, the contribution limit is $18,500 -- plus
an additional $6,000 "catch-up" contribution for those aged 50 and
older. Your employer may impose a limit on your contributions, too. The IRS
typically increases the contribution limits each year.
Catch-up contributions: As mentioned above, older workers are allowed to contribute an extra
$6,000 into their accounts in 2018, and these amounts are periodically
increased along with the base limit for workers under age 50.
Profit-sharing
contributions: While 401(k) accounts are
primarily funded by employees' elective deferrals and employer matches, they
can also be set up to receive a third kind of contribution: profit-sharing
contributions. Matching contributions are dependent on employee contributions,
but profit-sharing contributions come from an employer without the worker
having had to contribute anything. They will generally be set at a certain
percentage of salary and will apply to every employee. They may not be granted
in every year, the percentage of the share may vary from year to year, and
plenty of companies do not offer these contributions at all.
Vesting schedules: Vesting schedules apply to lots
of financial matters, and they determine you when you actually own something
that's been given to you. With 401(k)s, for example, the contributions your
company makes to your account may be yours immediately, or they may
"vest" over a number of years. One vesting schedule, for example, may
have you entitled to the first 25% of your employer's matching contributions
immediately, the next 25% after one year, another 25% after two years, and the
remaining 25% after three years. Vesting schedules are designed to motivate you
to stay with your employer. Some vesting schedules are all-or-nothing: If you don't
remain employed for a certain number of years, you forfeit all company
contributions.
Required minimum distributions (RMDs): Like traditional IRAs (but not
Roth IRAs), 401(k)s come with required minimum distributions that
you must begin taking annually beginning by April 1 of the year after you turn
70 1/2 -- or when you retire, whichever comes later. In the following years,
the RMD deadline is Dec. 31. If you fail to withdraw the required amount,
you'll pay a hefty 50% penalty on the amount not distributed.
Without further
ado, here are 10 important 401(k) rules to know and follow if you want to
accumulate a hefty retirement war chest.
Rule No. 1: Participate!
For starters, if
your employer offers a 401(k) plan, participate in it! Among workers who are
eligible to participate in a 401(k), about 1 in 6 do not, according to the 2017
Retirement Confidence Survey. And that's not good.
One reason the
numbers aren't worse is that more and more companies are automatically enrolling workers in 401(k)
plans. If that's what yours has done, that's good, but you should
look into exactly how that money is being invested, as it may be in overly
conservative investments that won't grow as quickly as you'd like. The younger
you are, the more money you should have in the stock market. More on that
later.
You may also be
auto-enrolled at a low contribution rate. Increase that rate as much as you can
afford to. Those who started saving early in their careers can often get by
saving 10% of their income, while those with some catching up to do should aim
for 15% or more.
If your employer
hasn't automatically enrolled you, then sign yourself up right away.
Rule No. 2: Max out employer matches
There may be a good
reason why you don't want to contribute a lot to your 401(k) account at the
moment, but you should still aim to contribute enough to get the maximum
matching funds from your employer. Why? Because it's free money.
If your company
will match contributions up to 6% of your salary, then contribute 6% of your
salary. Employers who match dollar-for-dollar are giving you a guaranteed 100%
return on your money, which is all but impossible to find elsewhere. If they
match 50% of your contributions, that's a guaranteed 50% return on your money,
which is still virtually unbeatable. Even Apple stock's average annual return
over the past 20 years -- about 30% -- can't touch that.
Rule No. 3: Figure out if your 401(k) plan is a good one
Next, it's
worth determining whether your 401(k) plan is relatively good. If it is, then
you'd do well to fund it aggressively. If it's not, then at least contribute
enough to get the full available match and consider putting the rest of your
retirement savings in a different sort of account, such as an IRA.
Below are the
kinds of features you'll find in the best 401(k) plans. Take a close look at
your employer's plan and see how many of them it has.
Employer match: Ideally, your company will offer matching funds --
84% of large companies do, per a 2017 survey from the Transamerica Center
for Retirement Center. Roughly 1 in 6 offer a match of 6% or more, so if
your match is anywhere near that, you're doing quite well. A match of less than
5% is more the norm, with many companies offering only 3% or less.
Continuous matching: Ideally, your employer will drop
its portion of 401(k) contributions into your account with every paycheck,
rather than once or twice a year. That gives the money more time to grow for
you and removes the risk that you'll lose out on some money if you leave your
job before a big payment.
Low fees: The lower the fees, the better, of course. Many
people don't even know that they pay any fees, and more than a quarter of
Americans are not aware of what they're being charged in their 401(k)s,
per a TDAmeritrade survey. A close look at the paperwork associated with
your 401(k) plan may reveal the fees you're charged -- or you may be able to
find out simply by asking your human resources manager or a representative of
the financial services company administering your employer's plan. You may
not be able to change your plan's fees, but if they're high, let your human
resources department know that you're not happy with them. One way to keep fees
low is to favor index funds when you invest
the money in your account, but even some index funds charge too much. If your
S&P 500 index fund is charging you 0.70% or 1%, for example, know that many
such funds charge 0.25% or 0.10% or less.
A good menu of investment options: You want high-performing
investments in the menu your 401(k) plan offers. It should include mutual funds
with strong track records and low fees. One of the best things to see is a
variety of low-fee index funds that track various broad market indexes, such as
the S&P 500, the whole U.S. market, the whole world market, or perhaps
certain regions such as Asia or Europe. Another potentially good option is a target-date fund, or
"life cycle" fund, which allocates your money across various stock
and bond index funds according to when you aim to retire, adjusting the
allocation as you approach retirement -- generally by reducing your stock
exposure and increasing your bond exposure.
A short vesting schedule: Ideally, your employer's
contributions to your 401(k) will vest immediately. If not, you want to be
vested in that money as soon as possible.
Auto-enrollment: If you're a procrastinator, a
company plan that features auto-enrollment of employees in its 401(k) plan will
get you up and running toward retirement -- though, ideally, you'll take the
initiative to increase your contributions and tweak your 401(k) investments.
Auto-escalation: Auto-escalation is where your
contribution percentage is increased every year, often without your even
noticing it. This can help you build wealth more quickly.
About three-quarters of plans that enroll workers automatically also
feature auto-escalation. If your plan doesn't offer this feature, just aim to
increase your saving percentage on your own. Odds are, you can increase it at a
faster rate than the auto-escalation will.
A Roth option: Employers are increasingly offering the option of a Roth 401(k) account. Like a Roth
IRA, it accepts only taxed contributions, not pre-tax contributions. However,
if you follow the rules, you can withdraw money from your account in retirement
tax-free. That's a
big deal for many retirees. If your Roth 401(k) account balance is $500,000 at
retirement, then you have a full $500,000 at your disposal. If that $500,000
were in a regular 401(k) account, your withdrawals would be taxed at your
ordinary income tax rate. A 24% tax rate would lop about $125,000 off your
account over time. About 70% of employers with retirement plans were
recently offering Roth 401(k)s. If your employer isn't one of them, let your
human resources department know that you'd like it to be offered.
Rule No. 4: For best results,
aim to max out contribution limits
One great thing
about 401(k) accounts is that they allow you to save much more each year than
an IRA. The contribution limit for 2018 is $18,500 for most people, plus an
additional $6,000 for those 50 or older, allowing older savers a maximum of
$24,500. Since you probably want to enjoy as comfortable a retirement as
possible, it's smart to sock away as much as you can, beginning as soon as you
can. The table below shows how smart it is to make bigger annual contributions
and to do so for as many years as possible. Always remember that your
earliest-invested dollars have the most time to grow for you, so they'll have
an outsize impact on your wealth in retirement.
Rule No. 5: Invest effectively
Socking away gobs
of money is great, but only if it's invested effectively and growing faster
than inflation. Money market accounts, CDs, and many bonds are unlikely to
deliver the growth you need to build up a nest egg that will last you through
retirement. So don't settle for your 401(k)'s default investment settings,
which are likely to be conservative ones that won't serve you well.
Putting long-term
savings in the stock market -- particularly in a low-fee, broad-market index
fund -- will give you good odds of growing your wealth considerably. Index
funds tend to outperform actively managed stock mutual
funds. There are bond and real estate-focused index funds, too.
Note
that it's to be expected that bonds will yield lower returns than stocks. And
within the world of stocks, there will be periods of very high growth and
periods of low growth or even losses.
Target-date funds are another good
option, offering convenient and automatic asset allocation and rebalancing. A
2030 fund, for example, will assume you plan to retire near 2030 and will
divide your assets between stocks and bonds accordingly, increasing your bond
holdings over time while thinning your stock holdings. These funds aren't
perfect, though. They sometimes charge high fees, and they all have different
allocation formulas. Find one that suits you, or skip it.
Rule No. 6: For higher returns, favor lower fees
Here's a closer
look at the issue of fees, because it's crucial to minimize the fees you pay.
If you're being charged sizable fees (and many people don't even realize it
when they are), you're fighting against a headwind. A Vanguard report ran
the numbers for investors saving money over a 40-year period and paying
different annual fees. The group paying the lowest fee, 0.25%, amassed about
24% more than those paying the highest fee, which was 1.25%. The table
below offers an eye-opening illustration of the power of fees, reflecting how
annual $10,000 contributions would grow at an annual average rate of 8% versus
7%. Over 30 years, you'd lose out on roughly $200,000 just because of a
1-percentage-point difference in fees!
Rule No. 7: Don't overload your 401(k) with your employer's stock
One mistake many
people make is stockpiling their 401(k) with their employer's stock -- indeed,
some companies even make their matching contributions in the form of company
stock. Yes, the company you work for is probably the one you know better than
any other, which can make you more confident in your expectations and arguably
less likely to encounter any nasty surprises. But still, even great
companies can fall on hard times -- or fail. And your employer already provides
much, if not most, of your financial support. If you're depending on your
employer for your income and your
retirement savings, then you have a lot of eggs in one basket. Try not to keep
too much of your net worth tied up in company stock -- perhaps not more than
10% at most.
Rule No. 8: Consider the Roth 401(k) if you can, for tax-free
withdrawals
Remember that just
as there are two main kinds of IRAs -- traditional and Roth -- many
companies now offer their workers two different kinds of 401(k)s, including a
Roth version. With a traditional IRA or 401(k), you contribute pre-tax money
that reduces your taxable income and, thereby, your tax bill for the year. When
you withdraw the money in retirement, it's taxed as ordinary income. With a
Roth IRA or 401(k), you contribute taxable money, so there's no up-front tax
break. But you eventually get a big tax break when you withdraw funds from the
account in retirement -- because you get to take all the money out of the
account tax-free if
you follow the rules. The Roth is especially worth considering if you still
have a few decades of work ahead of you, as you may be able to amass a really
big nest egg -- and then keep it all.
Another plus for
the Roth is that you won't be punished if federal income tax rates are hiked
significantly by the time you retire. No matter what they are, you won't be
paying them.
Rule No. 9: Let that money grow -- don't cash out or borrow from your
401(k)
It's also best to
let the money in your 401(k) stay there and do its job, building wealth for you
over the long term. Many people cash out their 401(k) account every time they
change jobs, but that's generally a terrible thing to do. Sure, you may have
only worked at a given company for three years and may not have much in your
account, but if you remove even $20,000 that could have kept growing for
another 25 years, you could lose out on about $137,000 in retirement money
(assuming an 8% average annual growth rate).
But wait -- there's
more! You will also most likely be withdrawing that money earlier than you're
supposed to, so you'll probably face a 10% early-withdrawal penalty, plus you'll be taxed on the
withdrawal at your income tax rate if the money is coming from a traditional
(not Roth) 401(k). When you change jobs, you might instead just roll over that 401(k) into an IRA.
Directly transferring your 401(k) funds to the 401(k) plan of your new employer
is also a good option.
Similarly, don't borrow from your 401(k) plan
unless it's an emergency and you really have no better option. That's another
way of stealing from your financial future, because even if you only take out
$25,000 and it's only for three years, you lose out on three years of growth
for that money. Over three years, $25,000 could become more than $31,000 if it
grows at an annual average rate of 8%. If it were growing at 10%, it would have
become more than $33,000.
Rule No. 10: View your 401(k) as part of your overall retirement plan
Finally, be sure to
think about your 401(k) as just one piece of your retirement preparedness
strategy. You may well have a regular, non-retirement investment account at a
brokerage -- or several of them. You may have one or more IRAs, too. Perhaps
you also have some mutual fund investments held at one or more mutual fund
companies and maybe some bonds. When you have money to sock away each year,
think strategically about where it would best be deployed. Your 401(k) may or
may not be the best place for all that money. For one thing, 401(k)s typically
have a limited menu of investment options. If your 401(k) offers one or more
low-fee, broad-market index funds, that might be all you need. But if you'd
like to invest in some individual stocks or different mutual funds, you may need
to do that outside your 401(k), such as in an IRA or in a regular, taxable
brokerage account.
For many
people, a good strategy is to first contribute enough to max out matching
401(k) funds and then to funnel any remaining income into an IRA until they
reach the maximum IRA contribution (which is $5,500 in 2018 for most people and
$6,500 for those 50 and older). Any further dollars after that can go into the
401(k) -- or some other account.
Think about Social Security, too, and learn
what it might offer you in retirement so that you can estimate how much retirement income you'll need to
generate on your own. The average Social Security retirement benefit was
recently $1,415 per month, or about $17,000 per year. You might well
collect more, though, and there are ways to increase your Social Security
benefits, too.
If you want the
greatest chance of being financially comfortable in retirement, remember the
rules above and make sure you're contributing aggressively to your retirement
account(s), paying attention to fees, not cashing out a 401(k) early, and so
on. You'll thank yourself later!
Click here for the original
article.