401(k)s are one of the most popular retirement savings accounts available, with nearly 79% of Americans eligible for a 401(k) through their employer, according to the U.S. Census Bureau. But despite their widespread availability, there are still a number of misconceptions floating around about 401(k)s.
These untruths could end up costing you more than you realize, even threatening your retirement security, if you don't learn the facts. Here's a look at the truth behind four of the most common 401(k) myths.
1. Your 401(k) is always the best place to invest your savings.
A 401(k) is often the best place to invest your savings, especially if your employer matches at least some of your contributions. But if you're not getting an employer match, then it depends on what kinds of fees your 401(k) charges. A 1% annual fee may not sound that bad at first, but realize that you'd pay $1,000 every year for every $100,000 you have in the account. As your retirement savings increases, your fees will increase too.
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You can get some idea of what kinds of fees your 401(k) charges by looking at the plan summary or the prospectus for your investments. There are two main categories of fees: expense ratios and administrative fees. Expense ratios are the annual fees that all mutual funds charge shareholders. Administrative fees cover things like recordkeeping.
In general, larger companies are able to offer more affordable 401(k)s because the administrative fees are spread out among more individuals. If you're paying more than 1% of your assets annually, you may be better off saving in an Individual Retirement Account (IRA) instead, as these accounts usually charge much lower fees.
2. You can leave your money in your 401(k) as long as you want.
You can leave your money in your 401(k) as long as you want, provided you're working. But once you retire, the rules become different. When you turn 70 ½, the government forces retirees to begin taking annual required minimum distributions (RMDs) from their 401(k)s so that Uncle Sam gets his cut in taxes. You can calculate your RMDs by using this worksheet. Divide the total value of your 401(k) by the distribution period next to your name to figure out how much you need to withdraw this year.
Failing to take your annual RMD out of your 401(k) results in a 50% penalty on the amount you should have taken out. The only exception is if you continue to work past 70 ½ and you don't own more than 5% of the company that you work for. In that case, your RMDs will kick in the year you retire.
3. 401(k) loans are a low-cost way to cover emergency expenses.
If you need a loan, you're allowed to borrow up to the lesser of $50,000 or 50% of your 401(k) balance. You will have to pay back what you borrow within five years (unless it's for a primary residence) and you'll have to pay interest, which is usually equivalent to the prime rate (currently 5.5%) plus 1%. It may not sound like a bad deal, but when you consider how much you lose in retirement savings by doing this, it looks like a less appealing option.
Say you borrow $10,000 from your 401(k) with a five-year loan term and a 6.5% interest rate. You'll end up paying back about $11,740 when you factor in the interest. But if you'd left that $10,000 in your 401(k) instead, you would have had $12,262 by the end of that five years, assuming an 8% rate of return. That's a $522 difference. And if you fail to pay back what you owe within the time frame, the government considers the outstanding balance a distribution, meaning you'll pay income tax on it, plus a 10% penalty tax if you're under 59 ½.
Of course, this is where the importance of having an emergency fund comes in, and why it's mission-critical to build up a cash reserve of between three to six months of expenses so you're safe from having to scrounge for funds.
But if you find yourself in need of some fast cash, consider borrowing from family or friends or taking out a personal loan instead. This way, your retirement savings will continue compounding and you won't risk the penalties.
4. Saving up to your employer 401(k) match is enough.
Some employers offer a match on some of your 401(k) contributions. The most common match is about 4.7% of your salary. So if you're contributing 4.7% and your employer is contributing 4.7%, there's 9.4% of your pay going into your 401(k) each pay period. That's certainly better than the 4.7% you're contributing on your own, but for most people, it isn't going to be nearly enough to fully support them for retirement.
Ideally, you should be saving at least 15% of your income for retirement, but this amount varies based on your personal circumstances. If you live in an expensive area or you plan to travel a lot in retirement, you;ll need to save more than this. Set aside some time to calculate how much you really need by estimating the length of your retirement and your estimated retirement living expenses. Then multiply your living expenses by the number of years of your retirement, adding 3% annually for inflation. To figure out how much you need to save on your own, subtract any money you expect to receive from Social Security, a pension, and any other income sources like an annuity or a side gig. Then, boost your 401(k) contributions to reflect this target number for your nest egg.
Understanding your 401(k) is crucial to setting your self up well for retirement by taking advantage of all this great savings vehicle has to offer. Take a close look at the details of the plan to figure out how much it's costing you and make sure your contributions are high enough to help you meet your retirement goals. Keep checking in periodically to make sure you're on track.
