The 401(k) is a powerful tool for retirement savings, and it's available to millions of Americans through their employer. And while there are a lot of general concepts that most people understand, such as how your payroll contributions can cut your taxes and that your employer often makes matching contributions, there are a handful of other surprising facts that you may not know at all.
Let's take a closer look at three 401(k) facts that you probably don't know about. A lack of knowledge could cost you a lot of money you were counting on in retirement.
Don't get caught off guard by these surprising 401(k) facts. Image source: Getty Images.
1. Your contribution limit may be lower than you think
According to IRS rules, the maximum amount you can contribute to your 401(k) in 2018 is $18,500, which is $500 higher than the 2017 limit. Furthermore, if you're 50 or older, the IRS allows you to contribute an extra $6,000 in "catch up" contributions.
But depending on the company you work for and how much you earn, your limits may be far lower.
The short version is this: If you earned more than $120,000, you're considered a "highly compensated employee" according to IRS rules. Each 401(k) is required to perform an annual test measuring the deferral percentages of both non-highly and highly compensated employees, and make sure that highly compensated employees are not benefiting from the plan in a way that's discriminatory to non-highly compensated employees.
If you're going to reach the $120,000 earnings threshold soon but don't know how this rule would affect you, speak with your human resources or benefits professional at work to learn whether this rule would limit your contributions.
2. Guess who pays the investing fees? You
Since your employer sponsors the plan, many people make the assumption that they don't pay any fees. Unfortunately, that's not only completely wrong, but many 401(k) investors pay some of the highest fees out there. Here's how it works.
Image source: Getty Images.
When you invest in a 401(k), you put your money into a limited group of mutual funds, often picked by the investment manager who runs the 401(k) for your employer. And each of these funds, whether it's stocks, bonds, or money market, charges a fee, typically described as an "expense ratio." The best way to describe the expense ratio is that it's the annual percentage the fund manager gets to run the fund.
I know what you're thinking: I don't get a bill, so my company pays the fees. Sorry, but you're still on the hook. The fund manager just takes their cut right out of the fund's assets.
Why does this matter? Two reasons: First, it's your money, and you deserve to know what it's going toward, and every dollar you pay in fees is a dollar that isn't compounding to help pay for your retirement. Second, there's a tremendous amount of evidence that the higher the fee a mutual fund charges, the more likely it is to underperform as an investment. Conversely, the lowest-cost funds, typically index funds, offer not only lower fees, but generally better returns. And that means more money when you retire.
So what's a 401(k) investor to do? Take the time to research the fees you are charged by the funds available in your plan. The fund prospectus will disclose the costs, as well as compare the fund's performance against the benchmark index. This can help you avoid the worst funds and pick the best (often cheapest) ones.
3. Those matching contributions may not be yours (at least not yet)
One of the nicest benefits of most 401(k) plans is that your employer may offer matching contributions, at least to a limit. For instance, your company might match, say, 50% of your contributions, up to 3% of your pay. So if you earn $50,000 and make the 3% contribution, that's $1,500 out of your paycheck, plus an extra $750 in free money from your company.
However, that money often comes with strings attached, in the form of a vesting schedule.
Image source: Getty Images.
So what's a vesting schedule? In short, it's how long it will take before those matching contributions are actually yours. To further explain, a vesting schedule may look something like this: Less than one year of employment, 0% of matching contributions are vested. Twenty percent vested after one year of employment. Forty percent vested after two years, increasing by 20% per year until five years when you become fully vested.
The idea behind a vesting schedule is that it incentivizes people to stay with the company, while also allowing the company to "get back" what it has invested in you in training and the time it takes to reach maximum productivity. Of course, these kinds of punitive "incentives" don't usually improve retention; they just lessen the cost to the company when someone leaves by stripping back a benefit.
If you're thinking about leaving your employer, make sure you know how you would be affected. If it's going to cost you money to leave, you may be able to use that as leverage when negotiating with potential new employers.
