The 401(k) is a popular retirement savings vehicle for a number of reasons, including its prevalence, potential for an employer match, and the income tax advantages -- all of which are appealing to workers socking away wages for retirement. There was $5.6 trillion in 401(k)s at the end of last year.
But with so many people using 401(k) plans, it's worth asking if they are really making the most out of all a 401(k) retirement plan has to offer. After all, you only want to retire once and you don't want to leave any money on the table. Here are five ways to maximize your 401(k) this year.
1. Employ tax-efficient asset location
Traditional 401(k) plans, which means they are non-Roth accounts, come with two major tax advantages: Contributions and investment gains are not taxable until you withdraw the money. The contribution is tax-deductible, so it lowers your taxable income in the year you make it which saves you taxes today. Then, investment gains are tax-deferred, so more money gets reinvested back into your portfolio, growing your nest egg.
One way to make the most of the tax deferral is by being aware of asset location, which is different from asset allocation. Asset location refers to putting tax-inefficient investments like those with high trading volume (such as actively managed mutual funds) or those that pay out a lot of interest or yield (such as high-yielding bonds and real estate investment trusts, or REITs) in places that don't tax the gains, like a 401(k).
By housing tax-inefficient investments in a 401(k) and rather than a regular brokerage account, you avoid the income tax levied on the interest and earnings of your investments. Accounts outside of the 401(k) are good places for index funds that are usually tax-efficient, or individual stocks that are also tax-efficient -- meaning you don't trade them a lot and don't incur taxable gains. Maximizing a 401(k) means making the most out of a 401(k)'s tax deferral by using that as a place for your tax-inefficient investments.
2. Avoid fees
You may not see a bill for investment services, but fees are debited from your 401(k) mutual funds every day. Fees are a drag on your return, which means less profit for you and a smaller nest egg in the long-run.
When choosing investments inside your 401(k), it's a good idea to know what the fees are. You can check with the fund administrator or read the required summary plan document that every 401(k) has. Some active mutual funds are more expensive than others. Fund families like Vanguard or T. Rowe Price usually are inexpensive, while other active mutual fund fees can be egregious. Try to keep 401(k) mutual fund fees below 1%.
3. Take advantage of in-service distributions
Don't like the mutual fund choices in your 401(k)? Some 401(k)s offer a brokerage solution where you can buy more different funds and stocks within the plan. That is one solution.
It's also possible that you could make an in-service distribution, which is a tax-free withdrawal direct to an Individual Retirement Account (IRA). Once the money from the 401(k) is transferred to your IRA, you have a wider selection of mutual funds or stocks to choose from. Check with your fund administrator or the summary plan document to see if in-service distributions are allowed. This can be a great way to increase your investment selection. Why limit yourself?
One downside to the in-service distribution to an IRA is that you lose the ability to take loans against your nest egg. Most 401(k) plans allow you to borrow from the plan, but IRAs do not. Though this can be a good thing, as experts advise against raiding your retirement account to foot expenses. IRAs do allow for hardship withdrawals, or special one-time expenses under age 59 1/2 for certain reasons.
4. Consider a Roth 401(k)
More and more 401(k) providers are starting to offer a Roth 401(k) option. Saving in a Roth 401(k) is not an all-or-nothing decision. You can make some Roth and some pre-tax or regular contributions up to the annual limit for 2019, which is $19,000.
The tax treatment of a Roth account works in the opposite way of a traditional 401(k), providing different benefits. Whereas a pre-tax contribution to a traditional 401(k) lowers your taxes today and the withdrawals are taxed, a Roth is funded by after-tax money, and qualified distributions are not taxed in retirement.
Using a Roth 401(k) can be a good idea for higher income earners who may not see as many benefits of the traditional 401(k), or people who think they might be in a higher tax bracket in retirement than they are now.
Investors may want to consider making some Roth contributions to diversify their future tax liability in retirement. That may be a long time away for younger savers, but if you can have some money in retirement coming out tax-free via the Roth, that may help keep your overall income tax rate down on other retirement income sources like Social Security or pensions.
5. Check your beneficiaries
As with any other account, make sure the beneficiaries are up to date. This may sound like mundane common sense, but our lives have a way of changing, and you want to make sure your primary and contingent beneficiaries are current. This is especially true for 401(k)s left behind at a previous employer which are sometimes forgotten.
The 401(k) is a great place to save for retirement, and if you maximize all of what the plan offers, your money can work smarter and harder.