Not everyone has access to a 401(k) plan through work, but if your employer does offer a retirement savings option, it certainly pays to capitalize on it. But if you don't understand the ins and outs of your plan, you could wind up missing out on valuable opportunities to grow your wealth. Here are a few important points you must know with regard to your 401(k).
1. The maximum amount you can contribute annually
Each year, the IRS sets a limit on how much workers are allowed to contribute to a 401(k) based on age. For 2019, you can sock away up to $19,000 if you're under 50. If you're 50 or older, you get a $6,000 catch-up provision that raises this limit to $25,000.
Beginning in 2020, the annual contribution limits for 401(k)s are rising. If you're under 50, you'll max out at $19,500, and if you're 50 or older, your catch-up increases to $6,500 so that your total allowable contribution for the year is $26,000.
If you fund a traditional 401(k), the money you contribute is made with pre-tax dollars, which means you immediately shield income from the IRS. That could translate to some huge savings. For example, if you're under 50 and max out your 401(k) this year at $19,000, and you're in the 24% tax bracket, that means you effectively shave $4,560 off of your 2019 IRS bill.
If you opt for a Roth 401(k) instead of a traditional one (which may or may not be an option, though a growing number of employer plans are incorporating a Roth savings feature), your contributions won't go in on a pre-tax basis, so you won't save money immediately by funding your account. But once you start taking withdrawals in retirement, that money will be yours tax-free, whereas with a traditional 401(k), your retirement withdrawals will be taxed as ordinary income.
2. The employer match you're entitled to
It's common practice for companies that sponsor 401(k) plans to also match employee contributions to varying degrees. There are no rules surrounding employee matches, though. One company might match employee contributions that total up to 10% of salary, while another might only match contributions up to 3% of salary. That's why it's important to figure out what your employer match looks like, and then contribute enough money to snag it in full.
Imagine, for instance, that your employer matches contributions of up to 5% of salary. If you earn $60,000 a year, that means you'll need to contribute $3,000 from your salary to get your full match. But once you do, you'll have an extra $3,000 coming your way. Failing to claim your match is essentially the same thing as passing up free money, so make every effort possible to avoid losing out on cash that could prove instrumental in helping you build your nest egg.
3. The fees associated with your plan
There are costs involved in administering a 401(k), and unfortunately, those tend to get passed on to individual participants. But while you generally can't change your 401(k)'s administrative fees, you can do your part to keep your investment fees to a minimum.
When you put money into a 401(k), you're supposed to invest it for added growth. And you generally get an array of choices with regard to your investments -- you can put your money into actively managed mutual funds, which are known to charge hefty fees for the privilege of benefiting from the expertise of their managers, or you can opt for lower-cost index funds, which aren't actively managed, but rather, track existing market indexes like the S&P 500.
In many cases, index funds are more than capable of matching the performance of more expensive actively managed funds, or even outperforming them -- but it's worth noting that in some cases, actively managed funds can be worth the fees they charge.
The point? Pay attention to the fees you're paying on your 401(k)'s investments, and make sure you're getting higher returns in exchange for higher fees. If not, you may want to do some shifting within your portfolio.
Oh, and if you don't see the word "fees" anywhere when reviewing your investment choices, look for the term "expense ratio" instead. That's basically just another term for fees, and the lower the expense ratio, the less your investment costs you.
Understanding how your 401(k) plan works can help you make the most of it. And that, in turn, can set the stage for a very comfortable retirement down the line.