401(k) plans are some of the best resources offered for saving and investing for retirement. In fact, these plans will make up the bulk of many people's retirement income.
Any contribution to a 401(k) plan is a good thing, but there are a few things you can do that will save you thousands in the long run and ensure more of your money is going toward your finances in retirement, not other fees or penalties.
1. Avoid target date funds
One of the limitations of a 401(k) plan is the investment options. Unlike regular brokerage accounts or IRAs, you can't purchase any stock or ETF you want in your 401(k) plan; your plan provider gives you options. Generally, these options consist of your company's stock (if it's public), market cap-based funds, and target date funds. Target date funds are mutual funds put together based on your expected retirement year. The closer you get to retirement, the more conservative the fund becomes.
Because target date funds are actively managed, they tend to be more expensive. The average expense ratio of a target date fund is 0.51%, meaning you'll pay $51 annually per $10,000 you have invested in the fund. At that rate, if your account gets to $100,000 and stays there for 20 years, you would have paid over $10,000 just in fees.
You can save yourself lots of money in the long run if you shy away from target date funds and take advantage of some index fund options your plan likely offers. It will be more hands-on -- as you should adjust your allocations every few years as your risk tolerance changes -- but the relatively small amount of time it takes to set your allocations is well worth the money saved.
2. Know about the 60-day rollover rule
You may find you get a new job and want your old 401(k) plan transferred to the plan offered by your new employer. This is considered a rollover and can either be done directly or indirectly. Direct rollovers can be from plan to plan, where your old plan provider transfers the money to your new plan provider, or you may be given a check written out to your new plan provider.
In other cases, you may receive the funds from your old 401(k) plan directly to put into your new plan, which is considered an indirect rollover. This is where the 60-day rule comes into play.
If you receive funds from your old 401(k) plan, you have 60 days to roll it over to your new plan (or redeposit it into the same plan). If you don't roll the funds over within those 60 days, the IRS will treat the total as a withdrawal. And if you're under age 59 1/2, this withdrawal will be considered an early withdrawal, and you will face a 10% penalty as well as owe income taxes on the total amount. And while you may not face the 10% penalty if you're 59 1/2 or older, you will still have to pay income taxes on the amount.
Any amount given to you is subjected to an automatic 20% income tax withholding when doing an indirect rollover, even if you plan to roll over the full amount. So if you're indirectly rolling over $100,000 from your old plan, your provider will withhold $20,000. And to complicate matters a bit, you'll be responsible for making up the $20,000 when you go to deposit the withdrawal into your new 401(k) plan.
There are three scenarios to be aware of:
- If you deposit the full $100,000 ($80,000 given to you and $20,000 from another income source), you can report the rollover as nontaxable.
- If you only deposit the $80,000 and not the $20,000 withheld, you'll report the $80,000 as a nontaxable rollover, but the $20,000 must be reported as taxable income and as taxes paid (plus the 10% penalty).
- If you don't redeposit any of the $100,000 within 60 days, you'll have to report the $100,000 as taxable income and the $20,000 withheld as taxes paid.
Knowing just how rollovers work can help save you thousands and prevent a tax hit that you were likely not expecting. The best way to navigate this, if at all possible, is to try to do direct rollovers.