8 Things You Must Know About 401(k)s
When you start a career, chances are you will be offered a 401(k) or similar retirement account as a way to save for retirement. These tax-advantaged plans allow you to put money aside through payroll deductions. Since its inception 40 years ago, the 401(k) has become the retirement plan of choice for most employers, largely replacing traditional pension plans.
To encourage employees across the company to get started saving money, many companies offer “match” programs: basically, if you save some money in your 401(k), your employers will “match” a portion – basically free money in your account.
You Get a Tax Break for Contributing to a 401(k)
The core of the 401(k)’s appeal is a tax break: The funds for it come from your salary, but before tax is levied. This lowers your taxable income and cuts your tax bill now. The term you’ll often see used is “pre-tax dollars.”
Yes, you will have to pay taxes someday. That’s why a 401(k) is a type of tax-deferred account, not tax-free.
There Are Contribution Limits for 401(k)s
Since the 401(k) is a powerful savings tool, the IRS sets an annual limit on how much money you can set aside in a 401(k). That amount is adjusted for inflation. For 2022, the 401(k)-contribution limit is $20,500.
If you’re 50 or older by year-end 2022, you can contribute an extra $6,500, for a total of $27,000. If you cannot afford to contribute the maximum, try to contribute at least enough to take full advantage of an employer match.
There Are Fees You Pay for Your 401(k)
As you may imagine, 401(k) plans come with fees, but study after study reveals that many savers don’t realize this, or if they do, don’t know how to find out what the fees are for the plan they participate in. Typically, fees will range from 0.5% to 2% of the plan assets, but, according to a recent Morningstar study, there can be considerable range, and the chances of higher fees goes up for smaller plans.
Pay attention to each fund’s expense ratio, which is a measure of a fund’s operating expenses expressed as an annual percentage. The lower the expense ratio, the less you’ll pay to invest. A total expense ratio of 1% or less is reasonable. Look at your 401(k) plan’s website to find a fund’s expense ratio.
The good news is that your plan may give you access to lower-cost institutional shares, which are cheaper than different share classes of the same investment bought through an independent retirement account (IRA).
Investment fees run with each fund, so you have some control over them based on your choices. You have less say in “plan administration fees” – which are the costs of running the entire program that your company has chosen.
You Can Choose From a Selection of Funds in Your 401(k)
In a 401(k), your employer will select the investment choices available to employees. You, as the employee, can then decide how to allocate your contribution among those available options. If you don’t make a selection for your contribution, your money will go to a default choice, likely a money-market fund or a target-date fund.
Most plans will offer actively managed domestic and international stock funds and domestic bond funds, plus a money-market fund. Many plans also offer low-cost index funds.
Increasingly popular on the 401(k) menu: target-date funds, which nearly 70% of plans offer. Over time, this type of fund typically shifts from a stock-heavy portfolio to a more conservative, bond-heavy portfolio by its target date.
You May Have a Roth 401(k) Option
Another choice to consider: a Roth 401(k), which almost 90% of plans offer, according to the Plan Sponsor Council of America. As with a Roth IRA, you are allowed to put in after-tax money in exchange for tax-free growth and tax-free withdrawals in the future.
One significant difference from a Roth IRA is that there are no income limits on Roth 401(k) contributions, so these accounts provide a way for high earners to access a Roth option. In 2022, you can contribute up to $20,500 to a Roth 401(k), a traditional 401(k) or a combination of the two. Workers 50 or older can contribute up to $27,000 annually.
But beware: Unlike IRA Roth conversions, you can’t undo a 401(k) Roth conversion — the decision is irrevocable.
If your employer offers a Roth option in your 401(k), it’s a great idea to invest in it, or at least consider investing a portion of your 401(k) contribution in the Roth. Contributions to a Roth 401(k) won’t reduce your tax bill now. While pretax salary goes into a regular 401(k), after-tax money funds the Roth. But as with Roth IRAs, withdrawals from Roth 401(k)s are tax- and penalty-free as long as you’ve had the account for five years and are at least 59½ when you take the money out.
You Can Roll Over a 401(k) Account
Workers generally have four options for their 401(k) when they leave a company: You can take a lump-sum distribution; you can leave the money in the 401(k); you can roll the money into an IRA; or, if you are going to a new employer, you may be able to roll the money to the new employer’s 401(k). (Note: Those with balances of less than $5,000 may not get the option to keep their money in their old plan.)
It’s usually best to keep the money in a tax sheltered account so it can continue to grow tax-deferred. Whether you roll the money into an IRA or a new 401(k), be sure to ask for a direct transfer from one account to the other. If the company cuts you a check, it will have to withhold 20% for taxes. And whatever money isn’t back in a retirement account within 60 days will become taxable. So if you don’t want that 20% to be considered a taxable distribution, you’ll have to use other assets to make up the difference. (Once you file your tax return for the year, you’ll get that withholding back.)
Eventually You Must Withdraw Money from a 401(k)
Uncle Sam won’t let you keep money in the 401(k) tax shelter forever. As with IRAs, 401(k)s have required minimum distributions. You must take your first RMD by April 1 in the year after you turn 72. You will have to calculate an RMD for each old 401(k) you own. Once you’ve determined the RMD, the money must then be withdrawn separately from each 401(k). Note that unlike Roth IRAs, Roth 401(k)s do have mandatory distributions starting at age 72.
If you hit that magic age, you are still working, and you don’t own 5% or more of the company, you don’t have to take an RMD from your current employer’s 401(k). And if you want to hold off on RMDs from old 401(k)s and IRAs, you could consider rolling all those assets into your current employer’s 401(k) plan.
You Can Borrow from Your 401(k)
A 401(k) loan, if your plan offers one, can be an appealing option, with interest rates usually set at the prime rate plus one percent. Plus, that interest goes back to you, since you’re borrowing from yourself. Win-win, right?
First, of all, as with any debt, you should think hard about why you’re taking it on and how you’re going to pay it back. Additionally, there are limits set by the IRS rules that govern 401(k)s: generally, the lesser of $50,000 or 50% of the account balance. Unless they’re for a primary residence, 401(k) loans must be repaid within five years payments must be made at least quarterly. And here’s a big catch: Remember that 401(k) plans are tied to your employment and your employer.
Same goes for the loans. If you leave your job, you generally have to pay back the loan within 30 to 60 days of your last day on the job or you’ll owe taxes on the balance plus a 10% penalty if you’re younger than 55.
Finally, you should also consider opportunity cost: You may be paying yourself 5% interest, but how much more could that money have been making if you’d left it invested?
If you want advice on fund selection or account management you can always call and speak to an advisor like the ones here at WWC!
This commentary was originally posted by Rachel L. Sheedy, Sandra Block – May 2, 2022
Source: 401(k)s: 10 Things You Must Know About These Retirement Savings Plans | Kiplinger
**Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.