401(k) plans are a big deal for American workers. How big? Well, consider that as of March 2018, about 55 million employees and millions of former employees had more than $5 trillion socked away in 401(k)s, according to the Investment Company Institute. Indeed, income from 401(k) accounts has been estimated to represent about 25% to 30% of Americans' total retirement income.

Offering generous contribution limits, matching funds from employers (in most cases), major tax savings, and sometimes even profit-sharing contributions, a 401(k) can be hard to beat. If you're not making the most of your 401(k), you may regret it down the road. So, let's go over the critical 401(k) rules so you can maximize your odds of having a comfortable, secure retirement.

Note: Much of the following information and guidance also applies to 403(b) accounts, 457 plans, and the U.S. government employee Thrift Savings Plan (TSP).

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What is a 401(k)?

401(k) accounts are "defined contribution" retirement accounts, named for a section of the Revenue Act of 1978 in which they were introduced. The term "defined contribution" refers to the fact that employees (and often their employers, too) regularly contribute a fixed amount of money. That defined contribution could be either a fixed dollar amount or a certain percentage of the employee's paycheck. The end value of the account is uncertain, as it all depends on how much time the money has to grow and how well the investments perform.

By contrast, pensions are "defined benefit" plans. Few people know exactly how much goes into them, but employees have a good idea of how much the pension will pay them in retirement benefits.

Of course, there's more to a 401(k) account than just that -- its main benefit is that it can save you a lot in taxes. As you'll learn below, contributing to a traditional 401(k) annually can shave your tax bill each year, while a Roth 401(k) will let you avoid paying some potentially hefty tax bills in the future. With both kinds of 401(k)s, the whole time your money is in your account, it's growing without any taxation.

Who's eligible for a 401(k)?

If you work for a company that offers a 401(k) plan, you're probably eligible to participate in it -- if not immediately, then soon. Unfortunately, many companies, especially small ones, don't offer 401(k)s. As of 2012, while 75% of employers surveyed with 1,000 or more employees offered 401(k) plans, only about 10% of those with 10 to 100 workers did so, according to a report from the Government Accountability Office.

Note that if you don't have a 401(k) plan available through work, you still have some options. You can focus on making the most of IRAs, for one thing, and you can always save and invest for retirement in a regular, non-tax-advantaged account, too. Those who are self-employed might want to look into SIMPLE or SEP IRAs, as well.

Defining 401(k) terms

Before we get into the important 401(k) rules, here's a quick review of some key 401(k)-related concepts:

  • Elective deferrals: These are the contributions you make to your 401(k). You elect to defer a fixed sum or percentage of each paycheck to your 401(k), so your take-home pay is reduced accordingly.
  • Employer match: While your elective deferrals will typically make up the majority of your 401(k)'s value, there's a good chance you'll enjoy some matching funds, too. That's when your employer adds some of its own money to your account according to a formula. Matching formulas vary, but a common one is when a company chips in 50% of contributions of up to 6% of your income. So if you earn $100,000 and contribute $6,000, your employer will add another $3,000 to your account. The average total company match was 4.7% as of 2016, per the Vanguard Group.
  • Contribution limits: You may not be able to contribute as much as you want to your 401(k), as the IRS imposes limits. For 2018, the contribution limit is $18,500 -- plus an additional $6,000 "catch-up" contribution for those aged 50 and older. Your employer may impose a limit on your contributions, too. The IRS typically increases the contribution limits each year.
  • Catch-up contributions: As mentioned above, older workers are allowed to contribute an extra $6,000 into their accounts in 2018, and these amounts are periodically increased along with the base limit for workers under age 50.
  • Profit-sharing contributions: While 401(k) accounts are primarily funded by employees' elective deferrals and employer matches, they can also be set up to receive a third kind of contribution: profit-sharing contributions. Matching contributions are dependent on employee contributions, but profit-sharing contributions come from an employer without the worker having had to contribute anything. They will generally be set at a certain percentage of salary and will apply to every employee. They may not be granted in every year, the percentage of the share may vary from year to year, and plenty of companies do not offer these contributions at all.
  • Vesting schedules: Vesting schedules apply to lots of financial matters, and they determine you when you actually own something that's been given to you. With 401(k)s, for example, the contributions your company makes to your account may be yours immediately, or they may "vest" over a number of years. One vesting schedule, for example, may have you entitled to the first 25% of your employer's matching contributions immediately, the next 25% after one year, another 25% after two years, and the remaining 25% after three years. Vesting schedules are designed to motivate you to stay with your employer. Some vesting schedules are all-or-nothing: If you don't remain employed for a certain number of years, you forfeit all company contributions.
  • Required minimum distributions (RMDs): Like traditional IRAs (but not Roth IRAs), 401(k)s come with required minimum distributions that you must begin taking annually beginning by April 1 of the year after you turn 70 1/2 -- or when you retire, whichever comes later. In the following years, the RMD deadline is Dec. 31. If you fail to withdraw the required amount, you'll pay a hefty 50% penalty on the amount not distributed.

Without further ado, here are 10 important 401(k) rules to know and follow if you want to accumulate a hefty retirement war chest.

pink piggy bank on which is written 401k

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Rule No. 1: Participate!

For starters, if your employer offers a 401(k) plan, participate in it! Among workers who are eligible to participate in a 401(k), about 1 in 6 do not, according to the 2017 Retirement Confidence Survey. And that's not good.

One reason the numbers aren't worse is that more and more companies are automatically enrolling workers in 401(k) plans. If that's what yours has done, that's good, but you should look into exactly how that money is being invested, as it may be in overly conservative investments that won't grow as quickly as you'd like. The younger you are, the more money you should have in the stock market. More on that later.

You may also be auto-enrolled at a low contribution rate. Increase that rate as much as you can afford to. Those who started saving early in their careers can often get by saving 10% of their income, while those with some catching up to do should aim for 15% or more.

If your employer hasn't automatically enrolled you, then sign yourself up right away.

Rule No. 2: Max out employer matches

There may be a good reason why you don't want to contribute a lot to your 401(k) account at the moment, but you should still aim to contribute enough to get the maximum matching funds from your employer. Why? Because it's free money.

If your company will match contributions up to 6% of your salary, then contribute 6% of your salary. Employers who match dollar-for-dollar are giving you a guaranteed 100% return on your money, which is all but impossible to find elsewhere. If they match 50% of your contributions, that's a guaranteed 50% return on your money, which is still virtually unbeatable. Even Apple stock's average annual return over the past 20 years -- about 30% -- can't touch that.

Rule No. 3: Figure out if your 401(k) plan is a good one

Next, it's worth determining whether your 401(k) plan is relatively good. If it is, then you'd do well to fund it aggressively. If it's not, then at least contribute enough to get the full available match and consider putting the rest of your retirement savings in a different sort of account, such as an IRA.

Below are the kinds of features you'll find in the best 401(k) plans. Take a close look at your employer's plan and see how many of them it has.

  • Employer match: Ideally, your company will offer matching funds -- 84% of large companies do, per a 2017 survey from the Transamerica Center for Retirement Center. Roughly 1 in 6 offer a match of 6% or more, so if your match is anywhere near that, you're doing quite well. A match of less than 5% is more the norm, with many companies offering only 3% or less.
  • Continuous matching: Ideally, your employer will drop its portion of 401(k) contributions into your account with every paycheck, rather than once or twice a year. That gives the money more time to grow for you and removes the risk that you'll lose out on some money if you leave your job before a big payment.
  • Low fees: The lower the fees, the better, of course. Many people don't even know that they pay any fees, and more than a quarter of Americans are not aware of what they're being charged in their 401(k)s, per a TDAmeritrade survey. A close look at the paperwork associated with your 401(k) plan may reveal the fees you're charged -- or you may be able to find out simply by asking your human resources manager or a representative of the financial services company administering your employer's plan. You may not be able to change your plan's fees, but if they're high, let your human resources department know that you're not happy with them. One way to keep fees low is to favor index funds when you invest the money in your account, but even some index funds charge too much. If your S&P 500 index fund is charging you 0.70% or 1%, for example, know that many such funds charge 0.25% or 0.10% or less.
  • A good menu of investment options: You want high-performing investments in the menu your 401(k) plan offers. It should include mutual funds with strong track records and low fees. One of the best things to see is a variety of low-fee index funds that track various broad market indexes, such as the S&P 500, the whole U.S. market, the whole world market, or perhaps certain regions such as Asia or Europe. Another potentially good option is a target-date fund, or "life cycle" fund, which allocates your money across various stock and bond index funds according to when you aim to retire, adjusting the allocation as you approach retirement -- generally by reducing your stock exposure and increasing your bond exposure.
  • A short vesting schedule: Ideally, your employer's contributions to your 401(k) will vest immediately. If not, you want to be vested in that money as soon as possible.
  • Auto-enrollment: If you're a procrastinator, a company plan that features auto-enrollment of employees in its 401(k) plan will get you up and running toward retirement -- though, ideally, you'll take the initiative to increase your contributions and tweak your 401(k) investments.
  • Auto-escalation: Auto-escalation is where your contribution percentage is increased every year, often without your even noticing it. This can help you build wealth more quickly. About three-quarters of plans that enroll workers automatically also feature auto-escalation. If your plan doesn't offer this feature, just aim to increase your saving percentage on your own. Odds are, you can increase it at a faster rate than the auto-escalation will.
  • A Roth option: Employers are increasingly offering the option of a Roth 401(k) account. Like a Roth IRA, it accepts only taxed contributions, not pre-tax contributions. However, if you follow the rules, you can withdraw money from your account in retirement tax-free. That's a big deal for many retirees. If your Roth 401(k) account balance is $500,000 at retirement, then you have a full $500,000 at your disposal. If that $500,000 were in a regular 401(k) account, your withdrawals would be taxed at your ordinary income tax rate. A 24% tax rate would lop about $125,000 off your account over time. About 70% of employers with retirement plans were recently offering Roth 401(k)s. If your employer isn't one of them, let your human resources department know that you'd like it to be offered.

You can compare your employer's 401(k) with those of other companies at BrightScope.com.

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Rule No. 4: For best results, aim to max out contribution limits

One great thing about 401(k) accounts is that they allow you to save much more each year than an IRA. The contribution limit for 2018 is $18,500 for most people, plus an additional $6,000 for those 50 or older, allowing older savers a maximum of $24,500. Since you probably want to enjoy as comfortable a retirement as possible, it's smart to sock away as much as you can, beginning as soon as you can. The table below shows how smart it is to make bigger annual contributions and to do so for as many years as possible. Always remember that your earliest-invested dollars have the most time to grow for you, so they'll have an outsize impact on your wealth in retirement.

Growing at 8% for

$10,000 invested annually

$15,000 invested annually

$20,000 invested annually

3 years

$35,061

$52,592

$70,122

5 years

$63,359

$95,039

$126,719

10 years

$156,455

$234,682

$312,910

15 years

$293,243

$439,864

$586,486

20 years

$494,229

$741,344

$988,458

25 years

$789,544

$1.2 million

$1.6 million

Source: Calculations by author.

Rule No. 5: Invest effectively

Socking away gobs of money is great, but only if it's invested effectively and growing faster than inflation. Money market accounts, CDs, and many bonds are unlikely to deliver the growth you need to build up a nest egg that will last you through retirement. So don't settle for your 401(k)'s default investment settings, which are likely to be conservative ones that won't serve you well.

Putting long-term savings in the stock market -- particularly in a low-fee, broad-market index fund -- will give you good odds of growing your wealth considerably. Index funds tend to outperform actively managed stock mutual funds. There are bond and real estate-focused index funds, too.

Here are some candidates to consider, along with their average annual growth rate over various periods:

Fund

5-Year Average Return

10-Year Average Return

15-Year Average Return

SPDR S&P 500 ETF (NYSEMKT:SPY)

10.70%

14.25%

8.61%

Vanguard Total Stock Market ETF (NYSEMKT:VTI)

10.31%

14.62%

8.97%

Vanguard Total World Stock ETF (NYSEMKT:VT)

6.33%

11.03%

N/A

Vanguard Total Bond Market Index Fund (NASDAQMUTFUND:VBMFX)

1.97%

3.79%

3.76%

Vanguard REIT Index Fund (NASDAQMUTFUND:VGSIX)

6.09%

10.64%

7.08%

Source: Morningstar.com data as of Nov. 14, 2018. 

Note that it's to be expected that bonds will yield lower returns than stocks. And within the world of stocks, there will be periods of very high growth and periods of low growth or even losses.

Target-date funds are another good option, offering convenient and automatic asset allocation and rebalancing. A 2030 fund, for example, will assume you plan to retire near 2030 and will divide your assets between stocks and bonds accordingly, increasing your bond holdings over time while thinning your stock holdings. These funds aren't perfect, though. They sometimes charge high fees, and they all have different allocation formulas. Find one that suits you, or skip it.

Rule No. 6: For higher returns, favor lower fees

Here's a closer look at the issue of fees, because it's crucial to minimize the fees you pay. If you're being charged sizable fees (and many people don't even realize it when they are), you're fighting against a headwind. A Vanguard report ran the numbers for investors saving money over a 40-year period and paying different annual fees. The group paying the lowest fee, 0.25%, amassed about 24% more than those paying the highest fee, which was 1.25%. The table below offers an eye-opening illustration of the power of fees, reflecting how annual $10,000 contributions would grow at an annual average rate of 8% versus 7%. Over 30 years, you'd lose out on roughly $200,000 just because of a 1-percentage-point difference in fees!

Investing Period

Balance at 7% Growth

Balance at 8% Growth

10 Years

$147,836

$156,455

20 Years

$438,652

$494,229

30 Years

$1 million

$1.2 million

40 years

$2.1 million

$2.8 million

Source: Author calculations. 

Rule No. 7: Don't overload your 401(k) with your employer's stock

One mistake many people make is stockpiling their 401(k) with their employer's stock -- indeed, some companies even make their matching contributions in the form of company stock. Yes, the company you work for is probably the one you know better than any other, which can make you more confident in your expectations and arguably less likely to encounter any nasty surprises. But still, even great companies can fall on hard times -- or fail. And your employer already provides much, if not most, of your financial support. If you're depending on your employer for your income and your retirement savings, then you have a lot of eggs in one basket. Try not to keep too much of your net worth tied up in company stock -- perhaps not more than 10% at most.

three eggs on which are written the words roth, ira, and 401k, sitting on a bed of hundred dollar bills

Image source: Getty Images.

Rule No. 8: Consider the Roth 401(k) if you can, for tax-free withdrawals

Remember that just as there are two main kinds of IRAs -- traditional and Roth -- many companies now offer their workers two different kinds of 401(k)s, including a Roth version. With a traditional IRA or 401(k), you contribute pre-tax money that reduces your taxable income and, thereby, your tax bill for the year. When you withdraw the money in retirement, it's taxed as ordinary income. With a Roth IRA or 401(k), you contribute taxable money, so there's no up-front tax break. But you eventually get a big tax break when you withdraw funds from the account in retirement -- because you get to take all the money out of the account tax-free if you follow the rules. The Roth is especially worth considering if you still have a few decades of work ahead of you, as you may be able to amass a really big nest egg -- and then keep it all. 

Another plus for the Roth is that you won't be punished if federal income tax rates are hiked significantly by the time you retire. No matter what they are, you won't be paying them.

Rule No. 9: Let that money grow -- don't cash out or borrow from your 401(k)

It's also best to let the money in your 401(k) stay there and do its job, building wealth for you over the long term. Many people cash out their 401(k) account every time they change jobs, but that's generally a terrible thing to do. Sure, you may have only worked at a given company for three years and may not have much in your account, but if you remove even $20,000 that could have kept growing for another 25 years, you could lose out on about $137,000 in retirement money (assuming an 8% average annual growth rate).

But wait -- there's more! You will also most likely be withdrawing that money earlier than you're supposed to, so you'll probably face a 10% early-withdrawal penalty, plus you'll be taxed on the withdrawal at your income tax rate if the money is coming from a traditional (not Roth) 401(k). When you change jobs, you might instead just roll over that 401(k) into an IRA. Directly transferring your 401(k) funds to the 401(k) plan of your new employer is also a good option.

Similarly, don't borrow from your 401(k) plan unless it's an emergency and you really have no better option. That's another way of stealing from your financial future, because even if you only take out $25,000 and it's only for three years, you lose out on three years of growth for that money. Over three years, $25,000 could become more than $31,000 if it grows at an annual average rate of 8%. If it were growing at 10%, it would have become more than $33,000.

Rule No. 10: View your 401(k) as part of your overall retirement plan

Finally, be sure to think about your 401(k) as just one piece of your retirement preparedness strategy. You may well have a regular, non-retirement investment account at a brokerage -- or several of them. You may have one or more IRAs, too. Perhaps you also have some mutual fund investments held at one or more mutual fund companies and maybe some bonds. When you have money to sock away each year, think strategically about where it would best be deployed. Your 401(k) may or may not be the best place for all that money. For one thing, 401(k)s typically have a limited menu of investment options. If your 401(k) offers one or more low-fee, broad-market index funds, that might be all you need. But if you'd like to invest in some individual stocks or different mutual funds, you may need to do that outside your 401(k), such as in an IRA or in a regular, taxable brokerage account.

For many people, a good strategy is to first contribute enough to max out matching 401(k) funds and then to funnel any remaining income into an IRA until they reach the maximum IRA contribution (which is $5,500 in 2018 for most people and $6,500 for those 50 and older). Any further dollars after that can go into the 401(k) -- or some other account.

Think about Social Security, too, and learn what it might offer you in retirement so that you can estimate how much retirement income you'll need to generate on your own. The average Social Security retirement benefit was recently $1,415 per month, or about $17,000 per year. You might well collect more, though, and there are ways to increase your Social Security benefits, too.

If you want the greatest chance of being financially comfortable in retirement, remember the rules above and make sure you're contributing aggressively to your retirement account(s), paying attention to fees, not cashing out a 401(k) early, and so on. You'll thank yourself later!

Selena Maranjian owns shares of Apple. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, long December 2018 $271 puts on SPDR S&P 500, and short January 2019 $285 calls on SPDR S&P 500. The Motley Fool has a disclosure policy.