One of the most common types of retirement account available in today’s workplace is a 401(k). With social security increasingly hard to rely on, and the lack of pension plans available through employers today, it’s more important than ever to maximize your benefits. It all starts with understanding the 401(k). This guide will provide an overview of the details and features you should be aware of in order to get the most out of your 401(k) plan.
Guide to Understanding the 401(k)
1. Employee Contributions
The maximum an individual can contribute to their 401(k) in 2019 is $19,000. This does NOT include employer contributions. If over age 50, a catch-up contribution of $6,000 is allowed, for a maximum of $25,000.
2. Employer Contributions
Most employers offer a matching contribution up to a certain limit. It’s often stated as a match of 100% up to x%. What this means is your employer will contribute FREE money to your 401(k), up to a limit. Let’s say you worked at ABC company all of 2018 and earned $100,000. You contributed 10% towards your 401(k) for a total of $10,000 at the end of the year. ABC company has a match of 100% up to 4% of your compensation, meaning the company contributed $4,000 into your 401(k) (4% of $100,000) by the end of 2018.
The employer match is FREE money and there’s no reason not to contribute, at a minimum, up to your employers matching percentage.
3. Roth 401(k)
Most plans offer a Roth option. A Roth is an after-tax contribution as opposed to the traditional pre-tax. In contrast to a Roth IRA, there is no income limit to Roth 401(k) contributions. With the tax cut and jobs act, the majority of individuals and joint filers are paying less in taxes than prior to TCJA. Depending on your situation, stashing as much into Roth accounts could now be more appealing than ever.
For more insights on choosing between a Roth or Traditional account check out this article.
401(k) participants may pay towards the administration and record keeping costs of the plan. These fees are unavoidable if you wish to participate and are outlined in your companies summary plan description document.
The fees you can control are through investment choices. Low-cost index funds are the cheapest options available usually ranging between .08% and .2% of the assets invested in the fund ($1,000 invested would cost between 80 cents and 2 dollars annually). Over time, low-cost, passive index funds tend to outperform their active counterparts due to their fee structure. See here for data from Morningstar supporting this claim.
5. Asset Allocation
If you’re like most people and wish to take the set-it and forget-it strategy, using a target date fund, or asset allocation fund is the way to go. Target-date funds will adjust the amount of risk you’re taking the closer you get to retirement. For example, if you enroll in a 2055 target date fund and are 25 years old, the fund will largely be invested in stocks today. By the year 2040, it will have adjusted to hold more bonds, historically less risky than stocks. The idea being that the investor should take less risk with their portfolio the closer they get to distribution so they’re not exposing their nest egg to the day to day volatility of equity markets.
Asset allocation funds specifically let you determine how much risk you’d like to take. If in your 20’s and even 30’s in most cases, choosing aggressive funds makes sense. With the idea that over time more aggressive funds are potentially rewarded with higher returns. With 20, 30, or even 40 years until you begin withdrawals you can afford to weather the day-to-day volatility of the market.
Lastly, you may choose to build your own portfolio with individual funds. If you build a portfolio using multiple funds be aware that if you don’t rebalance annually, your original portfolios risk parameters will transform over time. This is due to the riskier assets tendency to grow or decrease in value faster than less risky assets. At a minimum, you’ll want to review your account annually to ensure you’re still comfortable with the allocation and rebalance accordingly.
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Optimize your Plan Services
1. Financial Adviser
Most 401(k) plans offer access to a financial adviser or representative that can help you with your asset allocation, basic retirement planning, and address any specific questions you may have about the funds available or features included in the plan. The advice a professional can provide, especially early on, is tremendously valuable in making sure you’re comfortable and on track.
2. Vesting Schedule
Employer contributions often have a vesting schedule associated with them. This means that if you were to leave the company after 2 years, according to the company-specific vesting schedule, you may only be eligible to keep up to 40% of what your employer has matched into your 401(k). This feature exists to encourage longevity at the company. However, all funds that are contributed as an employee into 401(k)’s are always 100% vested the employee.
3. Rollover Services
If you have previous employer 401(k) accounts it’s almost always smart to consolidate for the sake of time and simplicity. You can only contribute to your current employers 401(k) so it makes sense to roll over old 401(k)’s into your current plan or open a rollover IRA and move the funds there. The record keeper of your current 401(k) (the company listed on your monthly or annual statements) typically has a dedicated service that you can call to assist you with the rollover. Rollovers are a non-taxable event so you won’t trigger any penalties as long as the funds are deposited into the current 401(k), or rollover IRA within 60 days.
Situations in which it may not make sense to consolidate an old 401(k) into your current plan would be if your current plan has higher fees or bad investment options (also associated with high fees). In that case, it may make sense to keep it as is or move it to a Rollover IRA where the fees and investment options are under your control.
4. Automatic Contribution Increases
Ask your HR department if this option is available. If so, this works extremely well with the set-it and forget it strategy. The plan administrative services will automatically increase your contribution percentage each year typically by a minimum of 1%. If you’re used to getting a pay increase of even 3% each year, you won’t notice the increased savings amount and you’re getting closer to maxing out your 401(k) contributions. When you’re able to automate saving/investments it takes it out of sight and out mind, yet you have the peace of mind that you’re making progress towards long-term financial security.
If you need assistance understanding yourr 401(k) options, schedule a free consultation with us today.