Employer sponsored retirement plans can be awesome. They often offer a contribution match and the ease of payroll deductions. Let’s discuss some things that you should know about 401(k)s.
1. You (and others) are not contributing enough to your 401(k)s. Did you know that while average 401(k) balances are up, the average account still cannot support a person’s retirement? In fact, the average account balance is only five figures, up to $75,900 in 2012 from $46,200 in 2009 according to Fidelity Investments. You better be really frugal to live off less than $80 grand over 20 to 30 years.
Did you also know that over half of American workers have less than $25,000 in retirement savings? $25,000?! That will pay for maybe a year of super frugal living. Maybe. On what planet is $25,000 going to make your golden years golden?
You need to save more. Your family members and friends need to save more. SAVE MORE MONEY.
2. Job jumpers may not see the entire employer match. Believe it or not, employers don’t like throwing money away on people who don’t stick around for the long haul. That is why the employer match will likely have a vesting schedule that probably looks like the following:
- 20% vested after 1 year
- 40% vested after 2 years
- 60% vested after 3 years
- 80% vested after 4 years
- 100% vested after 5 years
Understand that some of your match will be forfeited if you leave your job before you are 100% vested. If you are a nerd like me with net worth spreadsheets, only count the match that you are vested in.
3. You can roll over your 401(k) with a past employer to a 401(k) with your current employer or an IRA. When you leave an employer, you have several options for roll over or distribution.
- Distribution: Cashing out your retirement account is not advisable. Taxes and penalties can eat up around 40% of your contributions and earnings. You wouldn’t borrow money at 40% interest, this is basically the same thing.
- Leave it alone: Depending on the size, your contributions will either stay in your past employer’s 401(k) or be automatically rolled over into an IRA with the same brokerage firm. This gives you little control over your investments, so I don’t recommend this.
- Roll it over into your new employer’s 401(k) program: While 401(k)s can be a great option for retirement savings, I see little point in rolling over one 401(k) to another. Why? The real draw to using a 401(k) for retirement savings is taking advantage of the employer match. Without a match and with limited investment options, it’s not the most attractive savings option.
- Roll it over into an IRA at a discount broker of your choice: Choosing a discount broker with low fees is the ideal option in my humble opinion. You’ll have total control over what you choose to invest in.
4. Your company may not allow you to enroll in your 401(k) program right way. While around half of employers allow immediate enrollment, others require you work for several months or even a year before you are eligible to participate in the 401(k) program. Know when you are able to enroll in order to take advantage of any match as soon as possible.
5. You may be automatically enrolled or you may need to actively enroll. Companies either have an opt-in or an opt-out program. Here’s the difference:
- Opt-in program: You do not participate in the 401(k) program until you actively enroll in it.
- Opt-out program: If you do nothing, you are automatically enrolled and contributing up to the match. This is my preference as studies show that participation rates are over 90% with an opt-out program. Why? It’s easier to do nothing than make choices.
Regardless of whether your company has an opt-in or opt-out program, make sure to enroll. Saving for retirement is so crucial. Show your future self some love and respect and start contributing today.
6. Your contributions are not limitless. You cannot contribute as much as you want to your retirement account. In 2013, the contribution limits for 401(k)s are $17,500 per year. This does not count any employer matching. The limit for contributions and matches are $51,000 for 2013.
7. You may or may not have a Roth option available. The difference between traditional and Roth 401(k)s are as follows:
- Traditional 401(k): Contributions are tax-free, distributions and earnings are taxed.
- Roth 401(k): Contributions are after tax, distributions and earnings are tax-free.
For many people, the Roth option is a great choice! While contributions are taxed normally, your distributions (including earnings) are not taxed. This is especially ideal if you suspect that you will be in a larger tax bracket at retirement.
8. You could be paying major fees. Due to Department of Labor rules, you must be given a schedule of your 401(k) fees. Understand how much you are paying for your investments including any management fees. If fees are too high for your liking, you may want to consider an IRA as an alternative.
9. You can take distributions at age 59 1/2, but you don’t have to take them until age 70 1/2. You can start receiving distributions without penalty at age 59 1/2 but it is not required. However, your first distribution will then be due by April 1 of the year after you turn 70 1/2. Subsequent withdrawals must be taken annually by December 31st. Yes, they make you take your own money out. Presumably so they aren’t tempted to spend it themselves…
This basic knowledge about 401(k)s will help you become an informed investor. I cannot stress #1 enough, please contribute to your 401(k) (or an alternative retirement savings vehicle) so you can retire with dignity.
What do you think are the most important things to know about 401(k)s? Is any of this information new to you?