Updated: Feb 15
The 401(k) plan has grown to become the most popular type of employer-sponsored savings plan in America. It is a way for you to save for retirement via direct payroll contributions, thus ensuring you have dependable income available when you retire.
If you are employed at a company offering a 401(k) plan, then it is in your best interest to understand the key benefits of this particular retirement investment strategy.
I’ve answered 11 typical questions received from inquisitive readers, and am sharing these insights with you below.
1. What are the benefits of a 401(k)?
Contributing to a 401(k) provides an automatic method to add to your future retirement fund. Your employer automatically deducts your contributions every paycheck, which means you won’t even miss the money.
Company sponsored 401(k) plans typically offer an employee match to encourage participation. This essentially means you have an opportunity to receive bonus money toward your future retirement fund. So if your company’s plan is among the 70% offering a matching contribution, don’t pass up the opportunity.
Participating in a company sponsored 401(k) plan offers two tax breaks. First, your contributions are tax-deductible. The money you contribute doesn't count toward your gross income for the year, lowering your tax bill. Second, your money grows tax-deferred, meaning your earnings are rolled back into the plan and don't have to be listed as income on your tax return until you begin to withdraw them. Your savings grow faster this way.
2. What if my company offers a Roth 401(k) option?
If you are employed at a company offering a Roth 401(k) plan as an optional alternative to the traditional 401(k) plan, then you should understand the major differences between the two before you decide which option is better suited for you.
The Roth 401(k) is a type of retirement savings plan that allows you to make contributions after taxes have been taken out. This type of investment account is well-suited for people who think they will be in a higher tax bracket in retirement than they are now, as withdrawals are tax-free.
Introduced in 2006, Roth 401(k) plans are relatively new. It was designed to combine features from the traditional 401(k) with the Roth IRA. Think of it as a hybrid. With a Roth 401(k) you can take advantage of the company match on your contributions just like a traditional 401(k). However, unlike your contributions, the employer's contribution is placed into a traditional 401(k) plan, and it is taxable upon withdrawal. Many employers have found the additional administrative demands of offering the Roth 401(k) outweigh the benefits to their employees and elect to not offer the option.
3. When should I participate in the 401(k) plan?
If your company offers a 401(k) plan, take action today! The earlier you begin to participate and the more you contribute each paycheck, the better your chances of accumulating a substantial retirement nest egg.
4. What investments can I choose?
Usually you must choose among a list of investments your employer’s plan offers. Some of the options you may be able to select include stock mutual funds, index funds, bond funds, or a target date funds. Your plan sponsor or a financial advisor can provide a recommendation for a fund based on your age and planned retirement date.
5. How much can I contribute?
The maximum 401(k) contribution for 2023 is $22,500 if you are under age 50 and $30,000 if you are over age 50. At the very least, you should contribute enough to get whatever company match your employer is offering. After all, this is free money.
If your budget allows you should contribute at least 15% of your salary to the 401(k).
6. How much can my employer match?
During 2020, the combined employee and employer contribution to a 401(k) is $57,000. This means if you contribute $26,000 an employer could hypothetically contribute $31,000. However, most employer contributions are based on a percentage of your pay. For example, if you make $200,000 each year, an employer will contribute 5% of your salary as a match to your 401(k) contribution. That would equate to being $10,000 from the employer even if you max out your contributions.
7. Do I get to keep the employer match if I leave the company?
Companies use benefits as incentive for employees to stay long term. For 401(k) participants, this means you’ll need to understand what the vesting schedule is before you make any major career moves. The schedule for your particular plan should be clearly spelled out in the information your employer provides about its 401(k) plan. If you don't see it, ask someone in your human resources department or the employee who provided you with new hire forms.
The process of becoming vested takes place on a schedule. If it's an Immediate Vesting Schedule, then you own the employer matching dollars as soon as they are contributed. If it's in your 401(k) account, it's yours. If it’s a Graded Vesting Schedule, then you will vest a certain percentage of the employer contribution over a period of time, until you are fully vested (you own 100% of the employer match). For example, it may take you 5 years to become fully vested beginning with 20% being vested at the end of your first year of employment. If it’s a Cliffed Vesting Schedule, you will become fully vested at a specific time, and there is no interim percentage vesting like with a graded vesting schedule. Employers have up to three years to vest employees in a cliff vesting schedule, meaning at the end of the 3rd year you’ll be fully vested.
Once you are indeed vested, then you own the rights to the money contributed by the company in your retirement account. If you leave the company's employment before you are vested, you will have to forfeit the matching 401(k) money.
8. If I leave my employer, what should I do with my 401(k)?
Either open an individual retirement account (IRA) and move the funds there. Or, roll the money into your new employer’s 401(k). We generally don’t recommend leaving money with an old employer because it is too easy to lose track of your accounts especially if you change jobs every few years.
9. When can I withdraw money from my 401(k)?
You can begin taking withdrawals from your 401(k) at age 59 ½. If you withdraw earlier, you will pay a 10% penalty to the IRS.
10. What are the biggest 401(k) mistakes?
The two biggest mistakes are not starting contributions early enough and withdrawing from a 401(k) for emergencies.
Not starting contributions early enough. If you start investing at age 35 you can invest $820 a month in a 401(k) with stocks and bonds and wind up with $1 million at age 65. If you wait until age 45 to invest, you will need $1,920 a month.
If you withdraw from your 401(k) for an emergency, you will likely not be able to save enough for a comfortable retirement. You should have an emergency savings account instead.
11. When is it a good idea to skip the 401(k) plan?
If your employer doesn’t offer match contributions with the company’s 401(k) plan, then you may be better off considering alternative investment strategies. Since the money you contribute to your 401(k) will be taxed later in life and often has limited investment options, you may want to opt for an alternative retirement savings account, such as a traditional or Roth IRA. A disadvantage with the IRA is the low cap to your annual contributions.
Plan for the future while protecting your assets. No matter how savvy you are at investing, there is no way to predict what our economy is going to look like several years from now. There are a few essential things to keep in mind:
Diversify your portfolio. Your 401(k) plan should be one of the eggs in your metaphoric basket.
Remember corrections are temporary. Keep in mind that the volatility of the market will always affect your assets to some degree. Corrections are normal and temporary.
Invest for the long term. No matter how close you are to retirement, stick to a sound investment strategy so your money will never run out.
Meet with a financial advisor. Schedule regular meetings with your financial advisor to ensure you know how your portfolio is growing towards meeting your future goals.
Are you interested in learning how a financial advisor can help you achieve your goals? Contact the Peak Wealth Planning team to see if you will benefit from a financial coach.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance, and estate planning advice. Peak Wealth Planning is a fee-based financial advisor based in Champaign, Illinois, and Fraser, Colorado.