Congrats—you have a new job! Now you need to thumb through that huge new employee benefits packet. One of the more confusing elements is the 401K and retirement savings. We asked finance experts to break them down for us.
What is a 401(k)?
A 401K is an employer-sponsored retirement savings account, and it’s one of the smartest ways to save for your golden years. The account allows employees to invest tax-free and accumulate earnings. A 401(k) is a good deal because employees can invest before taxes are taken. However, at a later date, when the employee withdraws his or her money, taxes are taken.
How much should I contribute?
Many experts will recommend contributing between 10-15 percent of your income to your 401(k), but if your financial situation allows, you can put away even more towards your retirement savings (here’s what financial experts would do if they had extra cash). Eric Hutchinson, certified financial planner and author of the book “The Financial Briefing—Answers to Life’s Most Important Money Questions and Managing Director of United Capital Financial Advisers,” said, “Under current IRS rules, any individual participating in a 401(k) plan can save as much as $18,500 per year (this is the 2018 limit indexed to inflation). In addition, if the participant is age 50 or older, they can save an additional $6,000, for a total of $24,500 per year.”
Some employers will match some or all of your contributions to your plan—a great way to speed up your savings. Here are some other smart money-saving strategies. Different companies offer different levels of matching, so you’ll want to be clear on how much your employer is offering, and then try to contribute to obtain the maximum benefit.
Trevor Gerszt, CEO at Goldco, a top retirement service company for gold and silver IRAs, explains further: “A typical match might be a dollar-to-dollar match up to 3 percent, and then a 50 percent match up to 5 percent. What that means is that if you contribute 3 percent of your salary to a 401(k), your employer will also contribute another 3 percent. If you contribute 4 percent, your employer will then contribute 3.5 percent; you contribute 5 percent and the employer contributes 4 percent, and so forth. To get the maximum employer contribution you would have to contribute 7 percent of your salary; anything above that wouldn’t be matched.”
What is vesting?
While the money you contribute is fully yours no matter how long you stay at your job, vesting applies to the funds contributed by your employer. Some companies have no vesting requirements—meaning that the funds your employer contributes are 100 percent yours right away—but most plans require that you remain with the company for a certain period of time. “This is generally done to incentivize employees to stay with a company rather than taking their money and run,” said Gerszt. “For instance, an employer might specify that 20 percent of matching contributions are yours after your first year with the company, 40 percent after the second year, etc. until you’re 100 percent vested after five years.”
What’s the difference between a 401(k) and an IRA?
Where a 401(k) is sponsored by your employer, an IRA—or Individual Retirement Account—is something you can open with no employer sponsor. You can have both, if you wish. Gerszt said, “One of the primary differences is that annual contribution limits to IRAs are about a third of the limits for 401(k)s, so a 401(k) allows you to save a lot more. But IRAs, and particularly self-directed IRAs, often have a much broader range of assets in which investors can invest. Whether you need both is something you should ask your financial adviser.”
Are there tax advantages to having a 401(k)?
Your contributions are typically made pre-tax, allowing you to save more. Hutchinson said, “Once deposited in the plan account, all investment earnings are allowed to grow and compound on a tax-deferred basis, with no income taxes being due on any investment earnings until funds are withdrawn in retirement.” 401(k)s are also beneficial to your employer, as their contributions to your plan are tax-deductible.
Some employers also offer ROTH 401(k)’s, which are a bit different. Hutchinson said, “The employee pays income tax before the contribution is made, but once the after-tax dollars are contributed to the plan, subject to certain restrictions, the dollars can accumulate investment earnings tax-free and future withdrawals in retirement are income tax-free.”
Can I withdraw money in an emergency?
If you experience a financial emergency, you can in some cases, access your 401(k) funds, though be sure you need it—this could be one of the money mistakes retirees regret. According to 401kHelpCenter.com, there are certain things that qualify for an early withdrawal, including medical expenses, purchasing a home, tuition, funerals, and the like. These hardship withdrawals are subject to income tax and the 10 percent withdrawal penalty if you are under 59 and a half. You are not required to repay the amount you withdraw.
Should I select my own investments?
Some funds allow the fundholder to design their own portfolios. All three of our experts agreed that this can often be to your benefit, simply because you know your financial needs and risk tolerance better than anyone. However, if you are not totally at home making such decisions on your own, try one of the prepackaged plans or seek the help of a financial advisor for a personalized plan. Check out the 16 money mistakes you want to avoid.
What kind of management fees should I expect?
Management fees can vary based on the fund and on the size of the company you work for. Gerszt explained that larger firms are often able to negotiate lower fees for 401(k) investments or in some cases, eliminate them altogether. “The average cost of administering a 401(k) plan is around 1 percent, although for smaller employers it could be as high as 1.25 percent,” he said. “In general, anything higher than 1 percent will siphon away too much of your investment earnings and keep you from being able to accumulate as much retirement savings as you could over the course of your career.”
When I read my statements, what should I be looking for?
Most of us aren’t financial experts, but it’s important to keep an eye on your funds, regardless. People often focus on the gain-and-loss column, which is good to do, but she recommends keeping an eye on your allocation as well. For example, say you determined that you should hold 25 percent U.S. stocks, but as the U.S. market has rallied and your U.S. allocation rose to 30 percent, you may want to rebalance. In other words, sell some of the U.S. holdings to bring it down to the predetermined 25 percent. Meanwhile, use the proceeds to purchase another asset class that has not performed as well and slipped below its predetermined allocation.
We also recommend keeping tabs on the internal fees, particularly when you are offered new fund choices. See if there is an option for reducing the costs while maintaining the same basic allocation. For example, if you currently hold an actively managed U.S. equity fund, and your plan now offers a U.S. stock index fund, you may want to make that switch.