If you recently started your first job that offers a 401(k) retirement plan, or simply want to learn more about the plan you already have, here's a rundown of the most important topics to know about 401(k) investing, and some links to in-depth discussions on several 401(k) topics that can answer nearly every question you may have.
What is a 401(k)?
A 401(k) is a type of employer-sponsored retirement plan that is designed to help employees save for their retirement on a tax-deferred basis. 401(k) plans allow employees to defer a portion of their compensation and also allow employers to make contributions on the behalf of their employees. Money invested in a 401(k) can grow on a tax-advantaged basis and can let employees maximize the long-term benefits of compound investment gains.
Reasons to take advantage of your employer's 401(k) plan
There are several reasons to invest in your employer's 401(k) plan. Just to name a few:
- Compound growth: Let's say that you contribute $5,000 per year to an investment account for 30 years ($150,000 altogether) and that your investments earn the stock market's historical average rate of return. After 30 years, your account would be worth nearly $750,000. That's the magic of compound growth.
- Tax advantages: If you invest through a standard brokerage account, you'll have to pay capital gains tax if you sell an investment at a profit, as well as dividend tax on the dividends your investments generate. In a 401(k), you don't have to worry about either of these. What's more, your contributions can be tax-deductible.
- Employer contributions: Employer matching contributions are essentially free money that you can get, just for choosing to save for your own retirement. Generally, employers will match your contributions up to a certain percentage of your salary – either dollar-for-dollar or at a set percentage rate (50% is common).
- Simplicity: A 401(k) is a relatively easy way to invest. Once you set up your investments, minimal maintenance is required. Plus, 401(k) plans generally have investment professionals who will provide free retirement planning advice to investors.
- Loans: With a 401(k), you may be allowed to take a loan from your plan if you ever need the cash. This isn't an option if you invest in an IRA.
How much should you contribute to your 401(k)?
At a bare minimum, you should be contributing enough to your 401(k) to take full advantage of your employer's matching contributions, or else you're turning down free money.
For most Americans, however, this isn't enough. You might be surprised at how much you'll need to accumulate for a comfortable retirement, and how much of your salary you would need to set aside in order to get there. Social Security isn't designed to be enough to live on all by itself, so it might be a good idea to boost your 401(k) contributions. Even a seemingly small increase could make a big difference over the long run.
Standard versus Roth 401(k) contributions
Many 401(k) plans allow employees to make Roth 401(k) contributions. This means that instead of being tax-deductible in the current year, your eventual withdrawals in retirement will be completely tax-free. In contrast, traditional 401(k) contributions are not counted in your taxable income during the current year, but your 401(k) withdrawals in retirement will be taxed.
It's also important to note that employer contributions are always of the traditional variety. There is no such thing as a Roth matching contribution. Even if you designate your 401(k) contributions as Roth, your employer matching contributions will still be made on a tax-deferred basis, and will still be taxable when withdrawn.
How should you invest the money in your 401(k)?
401(k) plans typically offer a variety of mutual funds you can choose to invest in. Some of these are stock-based, or equity mutual funds. Others invest in bonds, which are also known as fixed-income securities. And, there's usually a cash-based, or money market fund option to choose from. There are also funds known as target-date, or lifecycle funds, that are intended to be one-stop investment options that blend several investment types together in an age-appropriate manner, although there are pros and cons to these.
Within each of these categories, there are several different sub-categories of funds, each with different goals and risk levels. Check out this discussion that can help you determine the best 401(k) funds for you.
In addition, it's important to know how to compare the costs of the funds in your 401(k).
Finally, perhaps even more important than the particular funds you choose is making sure you have an appropriate asset allocation -- that is, the percentage of your portfolio that is invested in stocks, bonds, and cash.
When can you withdraw money from your 401(k)?
The standard 401(k) withdrawal age is 59 ½ years old. This is the age at which anybody can take a withdrawal from their 401(k), penalty-free.
However, there are a few notable exceptions.
The "separation from service" exception allows you to start tapping into your 401(k) at age 55 if you're no longer working for the employer sponsoring the plan. You can also agree to take withdrawals as a series of substantially equal payments beginning at any age, but they must last for at least five years or until you turn 59 ½, whichever is later.
In addition, you can withdraw from your 401(k) to cover unreimbursed medical expenses in excess of 10% of your adjusted gross income (AGI), if the withdrawal is to cover unpaid taxes, or if you're ordered to withdraw the money as part of a divorce settlement.
Note that if you don't qualify for one of these exceptions, you can still withdraw money from your 401(k), but you'll face a 10% early withdrawal penalty from the IRS for doing so.
What about after you leave your job
Another important thing to know is what happens to your 401(k) after you leave your job. Depending on your account balance, plan, and new employment situation, there are four options that could potentially be available to you:
- Leave the money alone in your old employer's plan. It can stay invested and continue to grow, but no new contributions can be made.
- Combine your old 401(k) with your next employer's plan, if allowed.
- Roll your 401(k) over into an IRA.
- Cash it out, and take a lump-sum distribution.
Other than the last option, none of these are necessarily a bad idea. It's just a matter of figuring out which is best for you.
The best 401(k) advice: invest early and heavily
As a final thought, the hands-down best advice we can give to 401(k) beginners is to invest as much as you can as early as you can. Your money will never have more long-term compounding power than it does right now, so your younger years are the best time to get aggressive.