The 401(k) is the most common type of defined-contribution retirement plan for U.S. workers. However, these plans aren't well-understood by most people -- even the millions of Americans who participate in them. To help workers make the most of these powerful retirement saving tools, here are the answers to 10 common 401(k) questions.
1. Can I use my money before I retire?
It depends. The bad news is that some well-known exemptions to the early-withdrawal penalties, such as first-time home purchases and college expenses, only apply to IRAs, not 401(k) plans.
However, there are some cases in which you may be able to tap your account early. For example, you can withdraw money early for medical expenses in excess of 10% of your adjusted gross income. Or, if you become permanently disabled, you're free to withdraw from your account without penalty. If your plan permits it, you may also be able to borrow from your 401(k), which I'll discuss later.
2. What if I retire before age 59-1/2?
There are two special provisions that apply to people who retire before the age of 59-1/2, which is when most workers can start taking withdrawals from their 401(k)s without incurring penalties. First, the "separation from service" rule says that if you stop working for your employer after you turn 55, you can withdraw your money penalty-free. This applies if you quit your job, get fired, or retire.
Furthermore, at any age, you may be able to access your account early if you agree to withdraw the funds in a series of "substantially equal payments" based on your life expectancy, as defined by the IRS' life expectancy tables. This arrangement is known as a substantially equal periodic payment. However, an SEPP comes with a couple of big caveats. Namely, you can't use an SEPP while you're still working for the employer that provides the 401(k), and you must continue those distributions for five years or until you turn 59-1/2, whichever comes last. So if you're a long way from retirement, you might end up draining your savings substantially.
3. How much can I contribute to my 401(k)?
For the 2017 tax year, the IRS' elective deferral limit for 401(k) accounts is $18,000, with an additional $6,000 catch-up contribution allowed for participants aged 50 or older. Keep in mind that this only refers to money you voluntarily choose to have withheld from your pay. It doesn't include employer matching contributions, required automatic contributions, or any other form of 401(k) contribution. Including contributions from all sources, the maximums are $54,000 for participants under 50 and $60,000 for participants over 50.
4. How much should I contribute?
There is no one-size-fits-all answer to this, but at a bare minimum, you should contribute enough to take full advantage of your employer's matching program. Contributing less than that is literally giving away free money.
You can use a method like this one to determine how much retirement savings you'll need, and this should be the determining factor. Most 401(k) plans have some sort of calculator that can tell you how much you're on pace to accumulate by retirement, based on historical investment returns. If your expected 401(k) value at retirement is less than it should be, then it may be a good idea to increase your contribution rate.
5. What does it mean to be "vested"?
Essentially, "vesting" means that you own the money in your 401(k). You are always 100% vested in your elective contributions to a 401(k) plan, but your ownership of your employer's contributions may be governed by certain vesting rules. For example, my wife's 401(k) fully vests after five years of employment. When she started her job, she was 0% vested in her employer's matching contributions, and she became vested in an additional 20% of her employer's contributions each subsequent year. Your plan may have a different vesting rule, so check with your benefits administrator.
6. Can I borrow from my 401(k)?
If your employer's plan allows it (87% of them do), you can borrow money from your 401(k) and pay yourself back, with interest. You can borrow up to half of your 401(k) balance or $50,000, whichever is less.
Borrowing money from a 401(k) is generally a bad idea. Your account's compound growth will be reduced while the money is in your hands, and there are hefty penalties if you fail to repay the loan on schedule. That said, there are some circumstances where it could make sense. The interest rates are usually much lower than the rates offered by credit cards or personal loans through a bank -- and after all, you're paying all that interest to yourself.
7. What are my options with an old employer's 401(k)?
When you leave employment, you have several options for your old 401(k) account. You can leave it where it is, as long as it has more than a certain minimum threshold ($5,000 is common). You can also roll it over into an IRA. Or, you may be able to roll it into your current employer's plan. Of course, you have the option of cashing it out, which is rarely a wise choice. You can read a thorough guide to these options and how to determine the best move for you here.
8. How should I invest my 401(k)?
This question is far too complicated to answer here, especially since there's no way for me to know your 401(k)'s specific investment choices, but that doesn't mean that you can't choose your own 401(k) investments correctly. You just need a primer on asset allocation -- that is, how much of your money should be in stocks, bonds, and cash. You should also brush up on the types of investments your plan offers, e.g., "small-cap" and "global stock" funds. Here's a quick but thorough guide to asset allocation that tells you what you need to know to make wise decisions with your 401(k).
9. Can I contribute to a 401(k) and an IRA?
The short answer to this question is yes, you can contribute to a 401(k) and an IRA simultaneously. However, your income will determine whether you can take a tax deduction for traditional IRA contributions or contribute directly to a Roth IRA at all. For example, if you're single and have a 401(k) at work, then you can only deduct all of your traditional IRA contributions if your adjusted gross income (AGI) is $62,000 or less for 2017. Here's a guide to the income restrictions on both traditional and Roth IRAs for the 2016 and 2017 tax years.
10. Do I get a tax break for my 401(k) contributions?
Yes! 401(k) contributions are excluded from your federally taxable income. They do not reduce your income for Social Security or Medicare (payroll) taxes, but this is still a pretty good tax break. Furthermore, you don't need to itemize deductions to take advantage. When you get your W-2 for the year, your 401(k) contributions are automatically subtracted from the income you'll report to the IRS. I've referred to retirement saving as the smartest tax move you can make, and for good reason. Not only do you get some nice tax savings each year for contributing to your 401(k), but you'll help set yourself up for financial comfort years down the road.
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