18 Things You Should Know About 401(k)s


February 11, 2022

18 Things You Should Know About 401(k)s

February 11, 2022

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Before starting a new job, one of the key questions you’ve likely inquired about is your company’s 401(k) benefits. When you start the job, you’ll probably be handed a packet with the benefits information—and that’s it. You’re often left to your own devices to figure out the ins and outs of the plans available to you. It’s no secret that starting to save early and consistently contributing to your 401(k) can help you save money and work toward achieving your financial goals, especially in retirement. But that big packet of plan information can seem intimidating when you have a decision to make about contributing if you don’t know the basics of 401(k)s.

A 401(k) retirement plan is one of the most common ways employees save for retirement. According to the Investment Company Institute, there are about 60 million active participants in 401(k) plans over 600,000 company-sponsored plans as of 2020. This doesn’t include the millions of former employees and retirees who also hold 401(k) accounts but may not be actively contributing.

With so many people having access to and participating in 401(k)s, it’s important to understand the key features of 401(k) plans. We’ve discussed the basics of 401(k)s in this article, but here is a breakdown of 18 things you need to know about 401(k)s.

1. 401(k)s are tied to your job

401(k)s must be sponsored by an employer, and contributions must be in the form of payroll deductions (self-employed individuals have another 401(k) option they can set up). Your benefits manager can help you set up your account and contribution percentage. If you separate from your employer, you will no longer be able to contribute to that 401(k) plan.

2. 401(k) contributions offer tax breaks

401(k)s are defined contribution plans, meaning your contributions can be made pre-tax, thus lowering your taxable salary and helping you pay less in taxes. For example, if you make $6000/month and contribute $1000 to your 401(k), only $5000 of your monthly salary will be taxed. Additionally, your 401(k) contributions can help lower your income tax bracket, thus putting more money in your pocket.

3. Your investments grow tax-deferred

Your investments in your 401(k) grow tax-deferred, which means you’ll only pay taxes when you withdraw money. Decades of tax-deferred growth can boost your savings even more.

4. You’ll pay standard income taxes on your withdrawals on traditional 401(k)s

If you’ve contributed untaxed dollars, and your investments have grown tax-deferred, don’t think you won’t pay taxes somewhere along the way. You’ll pay regular income taxes when you begin withdrawing from your traditional 401(k) in retirement.

5. 401(k)s have a vesting schedule

Vesting essentially means how much of your 401(k) you “own” and can take with you if and when you leave a company. Everything YOU have contributed is automatically yours, but employer matching may vest at certain schedules, meaning if you leave the company in a certain timeframe from when your employer matches your contributions, that money doesn’t leave with you. Vesting schedules vary by employer, so make sure to get your company’s vesting schedule as it applies to you. For some, this can be a consideration when deciding to leave an employer.

6. Your employer/benefits provider may auto-enroll you in a 401(k)

According to the Plan Sponsor Council of America’s 2021 survey of 401(k) plans, 62% of plans use automatic enrollment, and for the first time ever, “the most common default deferral rate is now six percent of pay (32.9 percent) rather than the three percent of pay that has been the norm since 2006 (29.0 percent of plans).” This means that your plan might make you opt-out vs. opt-in or your contributions may not be set at the percentage you want.

7. You may not be able to contribute right away

Your employer may not allow you to contribute to a 401(k) immediately upon your employment. You may have to wait several months up to a year to be eligible.

8. 401(k)s have contribution limits

The IRS has set annual contribution limits for retirement plans. For 2022, you can contribute a maximum of $20,500 to your 401(k); if you’re 50 or older, you can contribute an additional $6,500 to your plan. These limits do not include employer matching; this is solely your contributions as the account owner. We highly recommend contributing the maximum amount to receive your full employer match if you cannot contribute the maximum allowable amount.

9. There are no income or age limits to participate

Some retirement accounts put limits to your contributions based on your annual income or age; this is not the case with 401(k)s. You’re eligible to participate, no matter your income, and you can continue to contribute as long as you’re employed by a company offering a 401(k).

10. Your employer may match your 401(k) contributions to a certain point

This is an incredibly advantageous benefit offering if your employer offers matching. The company will generally match you up fully or at 50% of your contributions up to a certain amount–for example, it might match you dollar for dollar or at 50 cents to your dollar up to 6% of your salary. Make sure you understand what they offer and the vesting schedule. As mentioned previously, don’t leave free money on the table by not contributing the maximum your employer will match.

11. 401(k)s have fees—and you pay them

Kiplinger reported that 37% of Americans didn’t know they paid fees on their 401(k)s at all. According to TD Ameritrade’s Retirement Pulse Survey, only 27% of 401(k) plan holders knew how much they were paying in fees. According to TD Ameritrade, fees come in the form of:

  • Plan fees (also called record-keeping fees) cover the day-to-day operation of a plan, including the 800 number you call when you have a question and the website you use to check your account.
  • Individual participant fees apply to the optional services a plan may offer, such as loans. You only pay the fee if you use the service, and it’s usually deducted directly from your account.
  • Investment fees are generally asset-based fees used to cover an investment’s management and operating costs. Mutual funds and exchange-traded funds (ETFs) refer to these fees as the expense ratio. The amount can vary, from a fraction of a percent to 2% or more of your account balance. The fees are ongoing and deducted from the investment’s performance (annual rate of return).

Your plan’s fees are calculated by a variety of factors, including the plan size, number of enrollees, provider, and your plan asset total. You should be able to consult with your benefits manager, who can provide resources and contacts to help evaluate your plan and the associated fees. According to Kiplinger, one critical area you can evaluate on your own is the fund’s expense ratio, which “is a measure of a fund’s operating expenses expressed as an annual percentage. The lower the expense ratio, the less you’ll pay to invest. A total expense ratio of 1% or less is reasonable. Look at your 401(k) plan’s website to find a fund’s expense ratio.”

12. 401(k)s have a selection of funds you can choose to invest in

While your employer and plan provider dictate which investment options will be available to plan participants, you can select where you want to allocate your money within those options. You’ll likely have options based on returns, risk tolerance, target dates, and other factors. If you don’t elect an allocation, your contributions will be put into a default fund.

13. Your employer may offer a Roth 401(k) option

A Roth 401(k) allows you to contribute after-tax dollars for tax-free growth and withdrawals in retirement. Not all employers offer Roth 401(k)s, but if you have the option, it can be nice to split your contributions between traditional and Roth 401(k)s to hedge future tax implications, as traditional withdrawals will be subject to taxes and Roth 401(k)s will not. Keep in mind that the contribution limit still applies, even if you’re splitting your contributions between the two account types. Also, employer 401(k) matching will automatically go into your traditional account.

14. You can also contribute to an IRA

Having a 401(k)—or a traditional and Roth 401(k)—does not exclude you from being able to contribute to an IRA. Other rules apply to IRAs and are outside the scope of this article.

15. You can often take loans on your 401(k)

You likely have the option to take a loan out on your 401(k) up to a certain amount. This can be helpful if you have an emergency or a bigger purchase you’d like to finance using your own money. You may have a fee to acquire the loan and will pay interest on the loan, but the interest is basically a payment to yourself because the money paid goes into your 401(k) account. Keep in mind that if you separate from your company and still have an outstanding loan, you will be required to repay it within a specific timeframe; if you don’t, the remaining loan amount will be considered a taxable distribution, and you will pay income taxes on it and potentially an early withdrawal penalty.

16. 401(k)s sometimes offer early withdrawals fee-free

The whole purpose of putting money into a 401(k) account is to save for retirement, so early withdrawals (before a certain age) typically incur a 10% early withdrawal penalty in addition to the standard income taxes you’ll pay on the money withdrawn. However, you can generally withdraw money after the age of 59.5 without incurring the early withdrawal penalty (though you’ll still pay income taxes). Additionally, you may be able to tap into your 401(k) penalty-free as early as 55 if you leave a job and invoke the separation from service rule. Becoming permanently and totally disabled and being called to active military duty may also allow you to withdraw from your 401(k) penalty-free.

17. You can roll over your 401(k)

You have several options for your 401(k) when you leave a job—two include rolling over your 401(k), 1) to an IRA, or 2) to your new employer’s 401(k), if you have over $5,000 in your old plan. Make sure you ask for a direct transfer vs. a manual transfer that you perform; if your old provider cuts you a check, they’ll automatically withhold 20% in taxes (you’ll get this back when you file your tax return, as long as you used other assets to make up the 20% difference when you roll the account over).

18. You will have to take required minimum distributions (RMDs) from your 401(k) at a certain age

Don’t forget—Uncle Sam is a tax machine, and he wants his money! You will be required to begin withdrawing money via RMDs by April 1st in the year after you turn 72. You can read more about required minimum distributions here. There are exceptions to taking RMDs from your current employer’s 401(k) if you’re still working there after age 72 and meet other requirements.

Consulting with a financial and tax professional can help you wade through your options and determine the best strategy for you and your situation. Understanding the tax implications of your retirement accounts is also an important part of financial and retirement planning.


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References

Internal Revenue Service. (November 17, 2021). IRS announces changes to retirement plans for 2022. https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022

Investment Company Institute. (October 11, 2021). Frequently Asked Questions About 401(k) Plan Research. https://www.ici.org/faqs/faq/401k/faqs_401k

O’Brien, Sarah. (March 14, 2017). What you need to know about 401(k) plans. CNBC. https://www.cnbc.com/2017/03/13/what-you-need-to-know-about-401k-plans.html

Plan Sponsor Council of America. (December 15, 2021). Retirement Plans are Looking More SECURE. https://www.psca.org/PR_2021_64thsurvey

Rosenberg, Dan. (August 21, 2020). Are 401(k) Fees Eating into Your Retirement? Now Might Be a Good Time to Check. TD Ameritrade. https://tickertape.tdameritrade.com/retirement/401k-fees-and-retirement-savings-15672

Sheedy, Rachel, & Wang, Michaela. (June 1, 2021). 401(k)s: 10 Things You Must Know About These Retirement Savings Plans. Kiplinger. https://www.kiplinger.com/retirement/retirement-plans/401ks

Williams, Sean. (August 28, 2016). 14 Things You Really Should Know About Your 401(k) Retirement Plans. The Motley Fool. https://www.fool.com/retirement/2016/08/28/14-things-you-really-should-know-about-401k-retire.aspx