The 401(k) plan has become the most common way that employers help their employees save for retirement. 401(k)s are useful tools for retirement saving, offering high contribution limits, valuable tax benefits, and convenient ways to save. Yet there are some things you should know about your 401(k) plan in order to use it most effectively. Below, we'll go through several issues you need to know about before you start participating in your 401(k).
1. The basics of 401(k)s
One reason why 401(k) plans are so popular is that they offer potentially huge tax benefits. For 2016 and 2017, you can elect to save up to $18,000 in your 401(k) account, and those who are aged 50 or older can add up to $6,000 more in what's known as a catch-up contribution. Many employers also add in contributions of their own, either through employer matching of their workers' contributions or by making profit-sharing contributions based on employees' salaries. Any money that you put into a traditional 401(k) account reduces your taxable income, so you'll typically have less money withheld for taxes and thus face a lower tax bill when you file your annual return. On top of that, your investments within a 401(k) are free from dividend and capital-gains taxes, which could save you huge sums of money throughout the life of the account.
However, 401(k)s aren't perfect. They come with a limited menu of investment options, and some employers don't offer many low-cost choices. In order to invest well, you'll need to look closely at what investments are available and then find the ones that are best suited to your needs at the lowest cost possible. In a few isolated cases, you might find that the costs of your 401(k) are so high that they outweigh the benefits, making it smarter just to use IRAs and other retirement savings alternatives instead. Most often, however, you can find at least a few viable low-cost investment options.
2. Know what you'll do with your 401(k) account if you change jobs
401(k) accounts are tied to your employer, so if you don't expect to work for the same company throughout your career, then you might wonder whether it makes sense to start saving in a 401(k) at your current employer. However, 401(k) money is portable, and you'll have the option to move your retirement money if you switch jobs in the future.
In fact, in some cases, employers will automatically close out your 401(k) account if you have a relatively small amount of money saved -- typically less than $5,000. In that case, it's essential to have that money transferred or rolled over either to another 401(k) plan at your new employer or to a rollover IRA. That way, you'll avoid any tax consequences from having the money distributed directly to you. If you make a mistake and take the money out of the 401(k) entirely, you'll typically owe tax on the money withdrawn, and you'll also owe a 10% early-withdrawal penalty if you're younger than age 59-1/2 unless you meet certain exceptions. However, as long as you know that those options are available to you, there's no reason not to start saving in a 401(k) plan even if you know that your days with a particular employer are numbered.
3. Be careful with 401(k) loans
One popular benefit of 401(k) plans is that most employers let their workers take loans from their accounts as necessary. This can be extremely handy, because you don't need to fill out the usual set of loan application documents that a bank or other financial institution would require. Typically, there's just a short form on which you request the loan, and many plans let you take up to half of your 401(k) assets in a loan, up to a maximum of $50,000.
The thing to keep in mind is that your 401(k) loan is like any other loan. You have to repay the loan in a timely manner, or else you'll be treated as though the loan were actually a distribution, and thus you'll suffer the tax and penalty consequences of taking money out of a 401(k). Most importantly, if you switch jobs, your 401(k) plan will demand immediate repayment of the loan within a very short time period -- even if the original loan still had years to run before the end of its term. Therefore you have to be extremely careful with 401(k) loans to make sure that your job is secure, or else you could get a nasty surprise in the form of required repayments.
401(k) plans can be extremely useful, and it usually makes a lot of sense to participate in them. By knowing the facts, you can make smart choices with your 401(k) and avoid the mistakes that other workers often make.