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What is a 401k Plan? - Top 10 things you should know

Updated: May 29, 2019

A 401k plan is an employer sponsored savings and investment plan that gives employees a tax incentive to put money away for retirement. The money you contribute comes directly out of your paycheck making it easy and automatic. The 401k plan will have a menu of different options for you to invest each contribution.

Here are the top 10 things you should know about your 401k plan at work:

Fees are the killer of happiness - Management fees and investment expenses are the biggest killer of 401k plans. They can cost you 6 figures over the course of your career. Make sure your plan offers quality investment options that include low cost index funds. Do not invest in funds that have high expense ratios.(1% or higher run) It is not worth it. Most index funds have expense ratios under 0.25%. The lower the better. If your investment options suck let your employer know about it and do not participate!

Traditional or Roth or Both? It is becoming very common for plans to offer a Roth option. You can split contributions between both. Remember, even if you are making Roth contributions, the employer match will always go into the traditional 401k. Here are the differences between the two:

  • Traditional 401k - Employee contributions are made pre-tax. This reduces taxable income for the current year. So if you earn $100k and contribute $20k you will only pay income taxes on $80k, saving you thousands in taxes (for now). The account will grow within the 401k plan without owing any taxes (tax deferred). In retirement, when withdrawals are taken from the 401k account, regular income taxes will be due at that time. These withdrawals in retirement will increase your income and can push you into a higher tax bracket. This is probably the right option if you are currently in a high tax bracket.

  • Roth 401k - Employee contributions are made after tax, but the money is never taxed again (As long as you follow the rules). You receive no current tax break for Roth contributions, but you end up with a big pile of tax free money in retirement. This is a great option if you are currently in a low tax bracket.

Employer Match - Some employers will match your contributions as an incentive to participate in the plan. All plans are different and can use different formulas so make sure you understand how the match works. An example would be matching $0.50 per $1.00 up to 6% of pay. If your salary is $100k you would have to contribute $6k to get the full match of $3k. Some plans might have a waiting period before you are eligible. Most plans also have a vesting schedule that you have to meet in order to keep the employer contributions.

Asset Allocation, Rebalancing and Company Stock - How you invest inside your 401k has a tremendous impact on the balance you will eventually have at retirement. There is no simple answer for everyone. This decision has to do with you and your feelings towards watching the value fluctuate, sometimes drastically. From my experience of working with hundreds of employees, the ones who have very little financial education are the same ones that do not like to invest in assets that can go down in value. This is a mistake that can cost you big time. I can sit here and tell you that the right thing to do is invest aggressively in stock funds if you have a long way to go until retirement, but you have to understand why that is and feel good about it or you will end up panicking during every market downturn.

The best way to invest is to first invest some time in learning about investing. That was a mouthful! Your 401k could end up being your largest asset and the key to your retirement happiness. Learn for yourself! Do not rely on the advice of others when it comes to your money. With that said, I do believe your 401k needs to be diversified appropriately with a mix of small, mid, large, value, growth, international and emerging market stock index funds. I also believe the percentage in each category should be rebalanced once it has drifted more than 10% from its original allocation. I also very strongly believe you should never invest in your companies stock. I did this personally and got burned when the bank I worked for dropped 98% and was bought out for a $1 a share during the financial crisis. You have invested enough just by working there, leave it at that.

Target Date Funds are like a one stop shop for your 401k account. These funds take care of the asset allocation decisions for you. All you need to do is pick the one that most closely corresponds with the year you plan on retiring. The fund will automatically adjust and become less risky as you move closer to retirement. These funds are designed to be the only investment in your portfolio. You should not put half of your account in a target retirement fund and then put the other half in other funds. It defeats the purpose of the Target Retirement Fund.

Because of their simplicity, these funds have become very popular over the last 5 years. Personally, I think you need to be very careful and make sure you understand what is going on under the hood of these funds. Just because you are approaching retirement does not mean the fund will be very low risk. I have seen funds with the same target date perform very differently than each other. I am not saying they are bad, but as with all investments make sure you understand how it works so there are no big surprises. Also, make sure the cost of the fund (expense ratio) is not high compared to other options available in the plan.

Contribution Limits - In 2019 you can contribute up to $19,000 in your 401k plan. If you are age 50 or older you can contribute an additional $6,000 catch up contribution.

Age 59 ½ is when withdrawals from a 401k are no longer subject to a 10% IRS penalty. This applies even if you are still working. The withdrawals are subject to income tax if it is a traditional 401k. If withdrawals are taken from the Roth 401k then they are tax free!

The rule of 55 - The IRS Rule of 55 allows an employee who leaves their job between the ages of 55 and 59 1/2 to pull money out of that 401(k) or 403(b) plan without penalty. Many people do not know about this rule which can be found on page 33 of IRS Publication 575. This can make it possible for some people to retire earlier than planned.

Loans and Hardship Withdrawals-

  • Loans - Most 401k plans will allow loans up to 50% of the vested account balance. Loans can be a great option if you need the funds for an emergency. You are borrowing your own money and paying yourself the interest payments. Loans typically have 5 year repayment schedules unless it is to purchase your primary residence then it can have up to a 15 year repayment schedule. A few important things to know with 401k loans:

  1. The amount of the loan will no longer be invested. (Can be good or bad depending on how the investments perform)

  2. If you default on the loan the unpaid balance will be treated as a withdrawal subject to taxes and penalties. (Could get very ugly)

  3. If you leave your job or get laid off the entire amount must be paid back by the due date of your federal tax return, including extensions. (Not a good situation to find yourself in)

  • Hardship Withdrawals - Some plans will allow hardship withdrawals. This should be an absolute last resort. In order to qualify you need to experience (and be able to provide proof) one of the following 6 hardships which are medical expenses, costs related to the purchase of a home, educational fees and expenses, prevent eviction or foreclosure, burial or funeral expenses and to repair damage to your home. Hardship withdrawals are subject to income tax and the 10% IRS penalty (with a few exceptions). Like I said - last resort!

When you leave your job- The big question when changing jobs is what do I do with my old 401k? You can no longer contribute to it and you would probably rather not have an extra account sitting with your old employer. Here are the 4 options with some pros and cons:

  1. Roll it over to an IRA - I like this option because you have much more control. You can choose any investment company (Vanguard, Betterment, Schwaab) and have tons of low cost investment options available.

  2. Leave it where it is - Your current 401k plan could have some great choices that will not be available elsewhere. For example, your plan could have a savings account with a high fixed rate of interest or they may offer funds with ridiculously low fees. Make sure to compare before you move it out.

  3. Roll it to your new employers 401k plan - Most plans allow incoming rollovers. Make sure to compare the new plan to other options available. This could simplify your life by having just the one account to manage. This also keeps the option of taking out a loan available.

  4. Get a fat check in the mail - Typically not a good idea. You will owe income taxes and penalties on this money while giving up the benefits of tax deferral. With that said, there can be circumstances where it is not a terrible move depending on what you are going to do with the money.(Like buy rental real estate which I have personally done). This only works if you have ample savings and an off year with very low income so the taxes are minimal even with the 10% IRS penalty.

To becoming great with money....

Rich McCormack, CFP®

School of Personal Finance


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