Pop quiz: How does a 401(k) actually work? You probably know that money comes out of your paycheck and goes into the account, that the government gives you a tax break on your contributions, and that the money grows over time to help cover expenses in retirement.
Many people think that's all there is to know, but there are a few other things that everyone should understand about their 401(k) if they want to get the most out of it. Here are three of them.
1. The contribution limits
You're allowed to contribute up to $19,500 to a 401(k) in 2020 or $26,000 if you're 50 or older. This does not include any company-matched funds. If you accidentally contribute more than this, you must request that your plan administrator remove the excess contribution, plus any earnings associated with it, before the tax deadline for the year. You'll owe taxes on your excess deferrals and the interest you took out, but you won't owe the 10% early withdrawal penalty.
If you don't correct your mistake before the tax deadline -- usually April 15 of the following year -- the excess contribution is essentially taxed twice. You pay taxes in the year you contributed the funds and again when you withdraw the funds later on.
If you've maxed out your 401(k) for the year and you'd like to set aside more money for retirement, you can put an additional $6,000 into an IRA in 2020 or $7,000 if you're 50 or older.
Contribution limits change from year to year, so keep an eye on them, especially if you find yourself regularly bumping up against them. Once you turn 50, you're allowed to start stashing away even more money for retirement.
2. The fees
Yes, your 401(k) charges you fees. You may not realize it because the money comes directly out of your account, so you never receive a bill. How much you pay depends upon your company's plan, the number of employees participating in it, and what your money's invested in. Larger companies are usually able to offer more-affordable 401(k)s than smaller companies because they have more employees to absorb the administrative costs, like record-keeping fees.
Your investments have their own fees, which can affect how quickly your retirement savings grow over time. Every mutual fund has an expense ratio, an annual fee that all shareholders must pay. You can find this listed as a percentage of your assets in your prospectus. Talk with your 401(k) plan administrator if you're unsure how to find out what you are paying. You should aim to pay 1% or less of your assets in fees every year.
If you're paying more than you'd like, talk to your employer about adding more low-cost investment options, like index funds. These are mutual funds that passively track a market index, like the S&P 500. The assets in an index fund change less frequently than the assets in a traditional mutual fund, so there's less work for fund managers to do and they can pass that saving along to you in the form of lower expense ratios.
3. The vesting schedule
You need to pay attention to your 401(k)'s vesting schedule if your company matches some of your contributions. This determines when you get to keep those employer-matched funds if you decide to leave the company. If you quit your job before you're fully vested, you could lose some or all of your employer-matched funds.
There are a few different types of vesting schedules. Immediate vesting means your employer-matched funds are yours to keep as soon as you earn them. This type of vesting is less common, but some companies that require employees to work for them for a certain number of months or years before enrolling in the 401(k) plan may use this.
Cliff vesting is where you must work for the company for a certain number of years before you can keep any of your employer-matched funds. Quitting before you've worked long enough will cost you all the employer-matched funds you earned during your time there.
Graded vesting gradually releases your employer-matched funds to you over time. If you have a five-year graded vesting schedule, you'd get to keep 20% of your employer-matched funds if you left the company after one year, 40% after two years, and so on.
You don't have to worry about vesting schedules if you've been with your company for decades, but if you've only worked there for a few years and you're considering quitting, it pays to understand the vesting schedule. Staying for a few more months or another year or two could make a big difference in your 401(k) balance.
We're just scratching the surface here. There are a lot of rules about how 401(k)s work, how much you can contribute, and when you can take money out. Understanding them can help you avoid costly mistakes and get the most out of your 401(k). You can ask your plan administrator specific questions, but it helps to stay on top of changes to 401(k) plan rules yourself so you can make the best choices.