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Getting the Most Out of Your 401(k)

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Do you want a 401(k) plan? Does your work offer one? What is a 401(k), anyway? A 401k account is the most popular employer sponsored retirement investment option for tax-deferred savings—it can help secure your retirement. If you are self-employed, freelance, or don’t have access to a 401k account, you can start an individual retirement account (IRA) instead. To maximize the benefits of your plan, you need to be conscious of what’s available to you and stay committed to getting the most out of your 401(k).

Male young professional reviewing 401(k) documents in his office.

What Is a 401(k) Plan?

A traditional 401(k) is an account that allows you to bank savings without paying tax on the money until you withdraw it after the age of 59½. This is what’s known as a pre-tax investment or contribution. You can have access to a 401(k) through your job, or a self-directed 401(k), and direct part of your paycheck to go into your account automatically. Your employer may match part or all of your pre-tax contributions. Company matched funds are also tax-deferred. This means you don’t have to pay taxes on this money until you make withdrawals after the age of 59 ½.

A Roth 401(k) is a post-tax contribution, which means you have to pay income taxes on contributions just like regular income, but you don’t have to pay income taxes on the withdrawals later in life. If you regularly contribute to a Roth 401(k) early in life, you can build up significant tax-exempt savings to bolster your retirement.

Matching Contributions

The contribution limit for a 401(k) is adjusted as needed to match inflation. In 2021, workers under age 50 can contribute $19,500 per year to a traditional 401(k), and workers age 50 and older can contribute $26,000 (this includes a $6,500 “catch-up contribution”).

Employers often match employee contributions dollar to dollar, or 50 cents to the dollar, or at any other percentage level. All employer-matched contributions are tax-deferred regardless if they are going to a Roth or traditional 401(k) account.

You can split your contributions between separate 401(k)s, including Roth 401(k)s. However, the total employee/employer contribution per year is capped at $58,000 across all 401(k)s in a company, including Roth 401(k)s (or at 100% of employee compensation, whichever is lesser.) For workers over 50, the contribution limit includes the catch-up contribution of $6,500, for a total of $64,500 in 2021.

Investing for Retirement with a 401(k) Plan

If your employer offers a 401(k) plan, they probably allow you to choose from a range of investment options managed by a financial services advisory group. You can choose more than one option from a variety of what are usually mutual funds.

The mutual funds are invested in a variety of asset classes for different goals and risk tolerances and can range from income funds to aggressive growth funds. Diversifying your portfolio can help reduce investment risk and give your retirement funds more stable, long-term growth.

Consider your risk tolerance as you choose which funds to invest in. If you are younger, and have a longer time horizon before you need to access your funds, you may be more risk-tolerant and want to invest in more volatile stocks that have better returns in the long run.

If you’re older, you may prefer a more conservative approach, keeping what wealth you have managed to amass safe while still staying ahead of inflation. Ideally, you’ll gradually reduce holdings in risky funds as you approach retirement, switching to assets that can provide more consistent retirement income.

How Much Should You Invest in a 401(k)?

Ideally, you should save between 10% and 15% of your income over your lifetime to create a good nest egg to bolster your social security income in retirement. If you’re starting off an have a tight budget, you should at least try to invest enough into your 401(k) to take advantage of the company match. While everyone’s retirement spending will look different, a good rule of thumb is to retire with enough to replace 80% of your normal working income.

401(k) Distribution and Rollovers

Once you maximize your 401(k) earnings by investing early and often, the final step in benefitting from your plan is knowing how, when and how much you can withdraw from your fund.

The distribution rules for 401(k) plans first and foremost require a triggering event to take place. A triggering event could be any one of the following:

  • You retire from or otherwise leave the job
  • You become disabled
  • A beneficiary inherits the fund upon your death
  • You reach age 59½
  • You experience a specific hardship (as defined by the plan)
  • The plan is terminated

If you retire or leave your job, you can roll your funds over into a 401(k) with a new employer or individual retirement account (IRA). If you have a balance of more than $5,000 in your old 401(k) you can keep the money with your old employer’s plan. If you have less than $5,000, the employer will usually force you to “cash out” in the form of a check. You then have 60 days to deposit the check into a new IRA or 401(k) account or it will be taxed like regular income and face the early withdrawal penalty if you’re younger than 59½.

If you reach age 59½, you can receive a payout from a 401(k) plan without penalties. If you have a traditional 401(k), keeping distributions small can help you stay in a low tax bracket (Consult your financial advisor or tax specialist for more information). You could spend significant tax dollars if you request a lump sum disbursement, so plan ahead to draw down your account in phases.

Unless you are still employed by the employer who holds your 401(k) at age 72, you’re mandated to start taking distributions at that time. Required minimum distributions (RMDs) are calculated by dividing the balance in your 401(k) by your life expectancy as provided by IRS actuarial tables. If you don’t make a withdrawal, the IRS will tax it at 50%, so make sure you’re taking distributions as required. If you don’t need the money but have an upcoming RMD, an alternative option is to donate your RMD to a charity through a qualified charitable distribution. This strategy can help reduce the taxes you would have incurred through an RMD.

Taking a Loan From Your 401(k) Plan

Some employers allow you to borrow against your 401(k) plan. This can typically be an amount up to 50% of the vested balance (the amount you’ve saved) up to a limit that is generally capped at $50,000. You’ll usually have to have the loan fully repaid within five years unless you used the money for a primary home purchase. If you don’t pay it back, it’s considered a distribution and you’ll have to pay the income taxes and any penalty owed. If you quit or lose your job with an outstanding 401(k) balance, you’ll generally have to pay the loan back sooner than the normal five-year period or face taxes and penalties for the distribution. Always use caution when taking out 401(k) loans because unpaid loans can set back your retirement plans.

These guidelines can help you get the most out of your 401(k), from contributing as much as possible each year to maximizing employer contributions to enjoying tax-exempt earnings after retirement. If your investments are made carefully and with forethought, and you roll over your 401(k) each time you switch employers, you’ll be able to achieve your retirement goals and live comfortably during your golden years.

This article is intended to be used for informational purposes and should not be considered financial advice. Consult a financial advisor, accountant or other financial professional to learn more about what strategies are appropriate for your situation.

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