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Americans have a bounty of investment tools to choose from when preparing for retirement, but no investment vehicle is more popular in the United States than the employer-sponsored 401(k).
As of 2010, based on data released by the Federal Reserve in 2013, there were 88.7 million workers in the U.S. participating in a 401(k) with roughly $4.5 trillion in assets being managed by mid-2013. The data also shows that more than 638,000 different 401(k) plans were being offered. As America's preferred retirement plan, it's important that you understand the ins and outs of what makes the 401(k) tick, because you retirement could very well depend on it. With this in mind, here are 14 things you should be aware of with your employer-sponsored 401(k) retirement plan.
1. Know what you can contribute annually
Perhaps the most important statistic worth knowing about 401(k)s is the annual contribution limit. According to the Internal Revenue Service, employees can contribute up to $18,000 annually in 2016 if they're age 49 or under. This large contribution limit, compared to $5,500 for a Roth IRA or Traditional IRA, is what makes the 401(k) such a popular investment tool.
2. There's a catch-up contribution for senior workers
However, senior workers, defined as those ages 50 and up, get the option of putting even more income away for retirement. A catch-up contribution of $6,000 exists for senior workers, which allows them to contribute up to $24,000 in 2016.
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3. There's no upper age limit on contributions
Like the Roth IRA, which is growing in popularity, there is no upper age limit where contributions are cut off with a 401(k). With a Traditional IRA, for instance, contributions cease in the year you turn 70 1/2. This isn't the case with a 401(k). As long as you remain employed with a company that offers a 401(k) retirement plan, you're eligible to make a contribution, regardless of your age.
4. You'll get a tax break for contributing to a 401(k)
One of the best aspects of 401(k) retirement plans is that you'll receive an upfront tax break for your contribution. Money put into a 401(k) is pre-tax dollars, meaning it reduces your current-year tax liability by the amount of your contribution. Thus, you're not only saving for your future, but possibly reducing your tax liability, or boosting your refund, in the current year, too.
5. Contribution limits are adjusted regularly
Contribution limits stand at $18,000 for workers aged 49 and under in 2016, and $24,000 for workers 50 and above. However, these contributions limits are regularly adjusted higher for inflation every couple of years. For example, the contribution limit in 2008 was $15,500, with a catch-up contribution of $5,000. Since 2008, the catch-up contribution has increased by $500 twice, while the standard worker contribution limit has increased by $500 to $1,000 on four separate occasions.
6. More companies than ever auto-enroll their workers
It's somewhat of a given that employees sometimes lack the follow-through to enroll in a 401(k). Therefore, more companies than ever have been automatically enrolling their employees in a 401(k) retirement plan, and requiring employees to take action to dis-enroll if they want. A study by Towers Watson that was released in late 2014 found that businesses with more than 80% employee participation rates in defined contribution plans had jumped from 50% in 2010 to 64% by 2014. By a similar token, there was a corresponding jump in the number of companies offering automatic enrollment from 57% in 2010 to 68% by 2014.
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7. Quite a few companies offer a match
Not all companies offer a 401(k), and not all companies that do offer a 401(k) match a percentage of their employees' annual salary. However, data from the American Benefits Council suggests that 95% of companies with a 401(k) retirement plan do indeed match some percentage of their employees' salary as a contribution. Employer matching is essentially free money for workers, and it's a great way for employers to retain talent and incentivize saving.
8. Your investment options are probably limited
It's important that you realize 401(k) retirement plans aren't perfect. For example, your investing universe is probably going to be limited to the financial firm your employer contracts to manage its 401(k) plans. According to the Plan Sponsor Council of America, the average 401(k) will offer 19 funds to choose from. For some workers that could be construed as a decent selection. However, when there are more than 7,000 tradable equities on U.S. stock exchanges, being limited to one- or two-dozen options may not be appealing.
9. You might be hit with a lot of management fees
In addition to limited investment options, workers should be aware that 401(k) fees (management, legal, marketing, bookkeeping, and so on) can add up over time. Just as your money compounds over time, so do your fees, which according to Robert Hiltonsmith of the public policy research group Demos, via Kiplinger, could total up to 30% of your 401(k) portfolio by the time you retire.
10. Know the earliest age to make penalty-free withdrawals
Another really important factoid you should know by heart is the age at which you can begin making penalty-free withdrawals: 59 1/2. With few exceptions (as we'll look at in the very next point), taking a withdrawal from your 401(k) prior to turning 59 1/2 will lead to ordinary income taxes plus a 10% early withdrawal penalty.
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11. Some penalty-free withdrawals exist at an early age, too
As noted above, there are a couple of exceptions that allow a worker to withdraw 401(k) funds before age 59 1/2 without being penalized. Examples include:
- Becoming totally and permanently disabled.
- Being a qualified military reservist called to active duty.
- Invoking the separation from service rule, which allows early retirees to access their 401(k) as early as age 55
- To pay unreimbursed medical expenses exceeding 10% of your adjusted gross income.
Workers may also have the opportunity to borrow against their 401(k) as a loan, with the interest paid going right in their future self's pocket.
12. You'll pay taxes when you begin taking distributions
Yet another critical fact you'll need to know is that 401(k)s are tax-deferred plans. This means you'll owe tax on the money you take out once you begin making withdrawals. Having a 401(k) has the positive effect of ensuring you're not solely reliant on Social Security during retirement, but it can certainly complicate your tax picture a bit. If you have a 401(k), you'll want to have a solid withdrawal plan in place years before you retire.
13. Don't forget about required minimum distributions
Although there's no age limit when it comes to contributions as long as a person is still working for an employer that offers a 401(k), there are typically required minimum distributions (RMD) that come into play as you age. With the exception of someone who's still working at age 70 1/2, retirees with a 401(k) are required to begin taking their RMD by age 70 1/2. Again, this is where a withdrawal plan can come in very handy.
14. You may be able to convert to a Roth 401(k)
Finally, keep in mind that you may have the option of contributing to, or converting a traditional 401(k) into, a Roth 401(k). Unlike a traditional 401(k), money contributed to a Roth 401(k) is considered after-tax. This means no current-year tax deduction as with a traditional 401(k), but your money will be allowed to grow tax-free for the life of the account. Keep in mind that matching contributions from your employer are going to be made toward your traditional 401(k), and that you have the opportunity split your contributions between the two plans if you like.
