A complete guide to 401(k) retirement plans

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If you’re working and already saving for retirement or plan to start socking away money soon, investing in a 401(k) plan can help you build a sizable nest egg.

If you’re thinking about signing up for a 401(k), or simply want to know more about how to take full advantage of this type of retirement savings vehicle, here’s everything you need to know.

Table of contents:

What is a 401(k) plan and what are the benefits?

A 401(k) plan is a tax-advantaged retirement savings tool offered by employers that allows eligible employees to contribute a portion of their salary up to a set amount each year.

Unlike traditional pension plans, in which the employer promises a specified monthly benefit at retirement, 401(k) plans are funded by contributions deducted directly from the employee’s paycheck. Many companies match contributions up to a certain percentage of your annual salary, say 4 or 5 percent, which is one of many notable 401(k) benefits.

The 401(k) has two varieties: the traditional 401(k) and the Roth 401(k).

  • Traditional 401(k): Employee contributions are made with pretax dollars, lowering your taxable income. Your contributions grow tax-deferred until withdrawn, meaning all of your money is working for you in the market. Any 401(k) withdrawal that occurs before age 59 1/2, however, may be subject to an additional tax and a 10 percent penalty.
  • Roth 401(k): Contributions are made with after-tax dollars, meaning you don’t get a tax benefit today. Your contributions grow tax-free until withdrawn in retirement, at age 59 1/2 and above, and then you’ll be able to avoid tax entirely on the distributions.

Your 401(k) contributions are automatically deducted from your paycheck and may be matched by your employer, making it easy to automate saving for retirement and invest regularly.

For 2020, the maximum contribution you can make to a 401(k) plan is $19,500, according to the IRS. Those age 50 and older can make an additional “catch-up” contribution up to $6,500. Importantly, any matching funds from your employer don’t count toward this limit. So if you receive an employer match, you can actually exceed this limit each year with no concern.

Employees need to consider several things as they get started with a 401(k) – the details of your employer’s plan, how much you should contribute, what investments to select and what happens to your plan when you leave your job.

Read the fine print on your plan

While 401(k) plans are broadly similar, each employer’s plan can differ in important ways, such as whether you can take a loan against your savings. Here are some key things to understand about your plan as you get started:

  • What are your company’s eligibility requirements and will you automatically be enrolled in the plan?
  • Will the plan automatically increase your contribution each year?
  • Does your company offer a matching contribution and how much is it?
  • What investment options does the plan offer? What do they cost and are those funds expensive relative to other available options?
  • Does the plan offer any third-party advice (such as from the plan’s administrator) or any option to have the account managed for you?
  • Can you invest in individual securities or do you have to stick to the funds provided in the plan?
  • Can you take a loan against your account balance? How much does the loan cost?

These are a few of the most important questions that you’ll want to answer as you get started with your 401(k). Don’t assume that all plans are alike because your employer may change important aspects of the plan – even beyond the basics, such as its matching contribution.

When it comes to how much of your pay you should contribute, everyone has different financial needs in retirement, but there are some general rules you can follow.

Contribute enough to take advantage of any matching dollars offered by your employer, says Catherine Golladay, executive vice president at Schwab Retirement Plan Services.

Whether your company match is dollar-for-dollar or something smaller, such as 50 cents on the dollar, don’t pass up the match. “Not doing so is like leaving money on the table,” she says.

After saving enough to get the full employer match, Golladay suggests paying off high-interest debt and building an emergency fund. Then, go back and maximize tax-advantaged retirement accounts, either the 401(k) or retirement accounts such as an IRA or Roth IRA.

More than 58 million Americans invest in 401(k)s and these retirement plans hold $6.2 trillion in assets, according to the Investment Company Institute, citing data as of Dec. 31, 2019. Plan participants can roll up substantial savings over the years of their working lives. Here’s how much the average American has in a 401(k) by age.

Bankrate’s calculator can help you decide which tax-advantaged account to stash additional funds in.

Most 401(k) plans have at least three investment choices, though others offer tens of plans. The average plan offers between eight and 12 investment options, according to the Financial Industry Regulatory Authority. The menu could include a mix of investments, such as mutual funds, company stock and index funds, as well as stable value funds (or cash), bond funds and so-called “target date” funds, which adjust your portfolio based on your years until retirement.

Fortunately, while you can pick your own funds if you’re the do-it-yourself type, you often don’t have to decide how to invest completely on your own.

“Many of today’s 401(k) plans include professional investment advice, which can be key in helping the participant make investment decisions based on their overall financial picture,” Golladay says.

Target date funds (TDFs) have become popular options because they automatically adjust the mix of investments over time to align with investors’ risk tolerance as they approach retirement. For example, they move money from higher-risk stock funds to lower-risk bond funds as you near retirement, so that you have a more stable portfolio when you need the money.

While target date funds meet many investors’ demands, they don’t fit every individual’s needs.

“While a TDF can be effective, a more tailored portfolio based on multiple data points about the investor may be the best option for some,” Golladay says.

Before you can decide how to allocate your contributions, determine your risk tolerance. It’s critical to know how well you can deal with volatility in your portfolio. You want to make sure you can sleep at night if financial markets turn turbulent and asset prices fall. But keep in mind that markets historically have recovered even after brutal bear markets, or stock market declines of 20 percent or more, which are typical during recessions.

Here are five other ways that you can maximize your 401(k) over time and generate higher returns.

What investments should you choose?

If you’re in your 20s or early 30s, you can afford to be more aggressive with your investments because you have more time to recover from market slumps. As you age, however, your asset allocation should shift to more conservative investments to protect the earnings.

“Generally speaking, younger workers will choose to allocate most of their portfolio to stocks, and over time, gradually move the balance toward more conservative bonds and other fixed income investments,” Golladay says.

Here are other smart moves to make with your 401(k), including how to earn a higher return by being aggressive with your investments and when not to.

Many 401(k) plans offer tools (online calculators, worksheets) for determining risk tolerance and suitable investment options. But if you’re not comfortable selecting funds or building an investment portfolio on your own, the best tool may be a competent financial planner. Consider hiring a planner to listen to your financial goals and evaluate your assets and earning ability to help you craft an asset allocation plan that will ensure a comfortable retirement.

Bankrate’s 401(K) calculator can help you estimate your savings over time.

Fortunately, a 401(k) offers portability, so you need not be stuck in a former plan, if you don’t like it. Workers have a few options for dealing with their old 401(k) after leaving a company:

You may also have the option of taking a cash distribution, or lump sum, but you’ll probably get hit with penalties and taxes if you’re not at least of retirement age.

Whichever path you choose, it’s important to understand the benefits and limitations of each option according to your unique financial situation, Golladay says.

Taking an early distribution could be disastrous for your retirement, and more than half of Americans say they are behind in saving for retirement, according to a Bankrate survey.

Is the 401(k) a good investment option?

A 401(k) is an excellent investment option, given its tax advantages and the potential for matching contributions from employers. Add in the ability to invest automatically and the tax-free benefits of a Roth 401(k), and workers have an attractive and accessible retirement plan.

Still, some investors are worried about investing in stocks because of their riskiness.

“All investments come with risk, but the fear of losing money should not inhibit someone from utilizing a 401(k),” Golladay says.

While markets go up and go down, history has shown that over the long run, they move up. As measured by the Standard & Poor’s 500 stock index, over time stocks returned around 10 percent annually. The S&P 500 comprises hundreds of America’s largest publicly traded companies.

That’s why investors, especially the risk-averse, should take a long-term approach to their retirement investments.

“In times of market volatility or uncertainty, it’s important to remember that panic isn’t a strategy, especially with an investment as long-term in nature as a 401(k),” Golladay says.

Other benefits of a 401(k)

If you need cash for an emergency or to pay down debt, your 401(k) plan may allow you to take out a loan and borrow up to 50 percent of your vested balance, but not more than $50,000. In most cases, you have to repay the money with interest within 5 years. While the interest payments go into your account – which means you are paying yourself back rather than giving your money to a bank – there are significant downsides.

When you make a 401(k) withdrawal, that money is no longer invested in the market, and therefore, you could miss out on gains if the asset prices continue to rise. Also, the original contributions to the account were made with pre-tax dollars, but the loan payments will be made with after-tax dollars. So, you’re losing a key tax benefit here.

If you leave your employer, you’ll also have to repay your loan faster, generally when taxes are due for the current tax year.

Try to avoid taking a 401(k) loan if at all possible, though it may be better than taking an early withdrawal. Here are other alternatives to both of these approaches.

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