For an overwhelming majority of working millennials, the 401(k) is our most powerful wealth-building tool. We recommend using Personal Capital’s free analysis tools for understanding the underlying fees and expenses in your 401(k).
Here’s our list of 7 important things you should know about your prized possession on your balance sheet:
1. Many Employers Will Match Contributions
It’s not uncommon to receive a match from your employer on the contributions you make into your 401(k) up to a certain percentage. 50% up to 6% on your contributions (3%) is relatively standard for a match.
Typically there is a vesting period of several years until the participant (you) are fully entitled to the match.
Make no mistake, this is free money. We recommend that everyone take full advantage of their employer’s matching limits, and contribute to the full max at a minimum before investing into other taxable accounts.
2. You Can Save On This Year’s Tax Bill..
Your 401(k) contributions are deducted from your gross pay BEFORE the IRS and Uncle Sam take their cut of your wages. This means that for every dollar you contribute into the plan, it’s one less dollar you pay taxes on until you retire!
Over the course of 40+ years of working and contributing, this tax savings can really add up!
3. ..Or Pay Taxes Now and None When You Retire
Your plan may have a “Roth” 401(k) option. Similar to a Roth IRA, when you make contributions to a Roth 401(k), you use post-tax dollars when you contribute, but then you never have to pay taxes on the funds when you take distributions.
This can be a powerful tool if you anticipate that your taxable income will be high upon retirement, or if generally you believe that taxes will go up, and not down, in the future.
If you have the option to do a Roth 401(k), it’s typically not mutually exclusive with the traditional 401(k). This means you can contribute to both accounts to get a match and maximize tax efficiency!
4. You Typically Have Options Inside
Many people “set and forget” their 401(k) to whatever allocation they pick when they sign up.
We recommend annual reviews at a minimum, and quarterly rebalancing for more experience investors, especially if you have an allocation of mutual funds.
One option that has become quite popular in the last decade are target date funds. Target Date funds allow you to pick a retirement year, and has professional portfolio management that changes the underlying asset allocation as you go from being heavily invested in equities, to transitioning to safer asset clases as you approach retirement.
If you invest in JPMorgan SmartRetirement 2050 Fund (JTSAX), for example, you wouldn’t need to check your portfolio as often, and certainly wouldn’t need to rebalance manually quarterly or even annually.
5. You Might Be Paying Lots of Fees
Most funds inside your 401(k) charge an underlying management fee, better known as the fund’s expense ratio.
On top of that, some 401(k) administrators also charge to custody your assets.
There can be redemption fees, transfer fees, and penalties associated with changing your allocation, so its best to contact your HR person and/or 401(k) plan administrator to see what fees you may be getting charged.
6. If You Leave Your Employer, You Can Set Up an IRA or Roll Over
In many cases, your best bet is to roll over your old 401(k) into your new plan, that way the balance can grow and compound over time.
However, if you move jobs and your new employer doesn’t provide a match in your 401(k), or you change professions to work in the public sector, or even become an entrepreneur, there are plenty of reasons why you can and should roll over old 401(k) and Roth 401(k) accounts into traditional IRA and Roth IRAs.
The rollover process is typically straightforward, and we recommend Fidelity as our custodian of choice when it comes to setting up an old rollover.
7. You Can Use Your 401(k) Before You Retire
There are specific rules about taking distributions from your 401(k) before legal retirement age.
If you take an early distribution, you’ll more than likely be subject to penalty taxes, which not only wipes out your retirement savings, but causes you to pay more than you should in taxes, which is never a good thing!
You can, however, use your 401(k) as a loan, where you would borrow an amount from the plan and pay yourself back, typically at a pre-determined interest rate. There’s also a $10,000 lifetime exemption for using funds for a downpayment on your first home.
We recommend that for most people, it doesn’t make much sense to use retirement savings any sooner than when you need them due to the power of compounding growth.