Saving for retirement in a 401(k) has a lot of benefits. For one thing, 401(k)s are funded automatically via payroll deductions, which means that opting into one of these plans could help your retirement savings stay on track.
Another perk of 401(k)s is that they offer much higher annual contribution limits than IRAs. So you have a prime opportunity to build up a lot of retirement wealth over time.
But there's some misinformation out there about 401(k)s that has the potential to hurt you financially. Here are three 401(k) myths you shouldn't believe.
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1. Every 401(k) comes with a match
Vanguard reports that 95% of employers on its platform offer some sort of 401(k) match. But that doesn't guarantee that your company will do the same. And if you aren't eligible for a 401(k) match, then you may actually want to consider saving for retirement outside of one of these plans.
One drawback of saving in a 401(k) is that you generally cannot invest your money in individual stocks. But IRAs do let you do that. So if you're good at researching and hand-picking stocks, you may want to prioritize an IRA over a 401(k) if there's no free money to be had.
2. Your plan's default investment option is your best one
Many 401(k)s are set to default to a target date fund if you don't actively choose your plan's investments. Target date funds are funds that adjust your risk profile based on how close you are to retirement. If you're decades away, you'll usually start off with riskier investments that grow increasingly conservative as retirement nears.
There are two big problems with target date funds you should know about, though. First, these funds sometimes invest too cautiously, which could result in lower returns over time.
Second, target date funds tend to come with high fees that can eat away at your 401(k)'s returns. So don't just settle for a target date fund if that's where your money lands initially. Instead, see if your 401(k) offers low-cost index funds that align with your investment strategy.
3. You'll automatically face a penalty for removing 401(k) funds prior to age 59 1/2
Normally, you'll be penalized 10% of your withdrawal amount for removing funds from a 401(k) prior to age 59 1/2. The same early withdrawal penalty applies to IRAs as well.
But there's an exception for 401(k)s known as the rule of 55. If you separate from your employer in the calendar year in which you turn 55 or later, you can take penalty-free withdrawals from that employer's 401(k) before turning 59 1/2.
This is an important rule to know, because what if you've managed to amass a $2.5 million nest egg by age 55, and that same year, your employer lets you go? You may not want to start over at a new full-time job at that stage of life. And with that much money, you may not have to.
So in a situation like that, it's helpful to know that you can start to withdraw from your 401(k) without a penalty. And you may, in that case, decide to just do some gig work to supplement your income rather than pursue another full-time job at a later age.
Saving in a 401(k) could lead to a very comfortable retirement. But it's important to fully understand how 401(k)s work and familiarize yourself with their nuances so you can make the most of your nest egg.
