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Millions of Americans will count on their 401(k) accounts to provide income when they retire. Depending on your situation and other retirement income sources such as Social Security and pensions, the money from your 401(k) could make -- or break -- your retirement.
Whether you're retired already or making sure you're on the right track, there are a number of important facts you should know about your 401(k). Here are five that everyone should understand. They mainly impact you after retiring, but you'll be better off understanding them before you reach retirement.
Know when you can take distributions penalty-free
Generally, the soonest that you can tap your 401(k) for retirement distributions is 59 1/2 without being subject to an extra 10% early withdrawal penalty. However, if you start taking distributions after leaving your employer during or after the year you turn 55, then your distributions would not be subject to the 10% penalty tax.
You can also avoid the 10% penalty tax if you retire early because of a qualifying disability, as well as several other exceptions including financial hardship.
You may have to take minimum distributions at 70 1/2
The IRS says you must start taking minimum distributions from your 401(k) "generally, April 1 following the later of the calendar year in which you reach age 70 1/2, or retire."
It's important to differentiate here between a 401(k) and an IRA. While you can delay RMDs from your 401(k) if you're still working, you must start taking required minimum distributions from your IRAs once you reach 70 1/2. One potential way around this if you are still working and don't need the income is to roll your IRA assets into your 401(k), if your plan allows you to do so.
Those distributions are taxable income (with this exception)
One of the benefits of contributing to a 401(k) is that you lower your taxes during your working career, since the contributions are pre-tax, reducing your taxable income. However, once you retire and start taking distributions, that money is treated as regular income by the IRS (and often by your state of residence) and subject to income tax.
There is an exception, however. If you've contributed to a Roth 401(k), those distributions would tax-free since your contributions would have been treated as taxable income while you were working.
You're paying fees (and maybe a lot more than you should)
A popular misconception is that you don't have to "pay anything" for funds invested in your 401(k), with many people wrongly assuming that their employer foots the bill for management fees. The reality is, you're still paying fees, and you may be paying more than you should by leaving your retirement assets in the 401(k).
The easy way to find out how much you're paying is to look in the prospectus for each fund you invest in and find the "expense ratio." This percentage is what the fund manager charges to run the fund. For instance, if you have $100,000 in a fund that charges a 1% expense ratio, you'll give the fund manager $1,000 that year.
And don't think just because you never get a bill that someone else is picking up the tab here. Nobody gets a bill, as the fund manager simply skims its cut directly from the fund's assets.
So, before you assume you're getting a free ride (you're almost certainly not), find out how much you're actually paying. It may be a lot more than you realize.
The 4% rule may not work for you
A common guide for how much money to withdraw each year is the "4% rule," which says to take out 4% of your retirement savings the first year of retirement and then adjust that amount up each year based on inflation. When the rule was first developed in the early 1990s, the idea was that a 4% withdrawal rate with small adjustments for cost of living increases would be sufficient to sustain the account balance through the several decades that most people lived after retiring.
Unfortunately, there's evidence that many retirees could need more than 4% from their retirement accounts to make ends meet each year. According to Vanguard, which manages the 401(k)s of millions of Americans, the median 401(k) balance for its clients 55-64 was $71,600 last year and $68,600 for those 65 and older. Based on the 4% rule, that's less than $240 per month in income.
If your 401(k) balance won't generate enough income at the 4% withdrawal rate to meet your income needs and you choose to take bigger distributions, you may end up with a lot less money than you were counting on later in life.
