A 401(k) account is a retirement plan sponsored by an employer and managed by a third party. They are a type of defined contribution retirement plan, which means you define what you put in, but not what you end up with when you retire. Using 401(k) investments, allows you to contribute part of your salary every month, and to defer tax on the contributions until you retire.
How Does a 401(k) Work?
Once you have decided how much to contribute each month, your employer deducts that from your salary and sends that money to the company that manages the account. These deductions are made before your salary is taxed. Employers may also make additional contributions to your 401(k) depending on their policy on contributions.
You will usually have a choice of 4 to 10 mutual funds to choose from, and your contributions can be spread between these funds.
When you reach retirement age will be able to withdraw from your 401(k), as a combination of a lump sum and monthly withdrawals. Withdrawals are taxed at your tax rate at the time of each withdrawal.
As an employee, you decide how much of your salary to invest in your 401(k) every month. If you are under 50, you can contribute up to $18,000 every year – so that’s $1,500 per month. If you are over 50 you can contribute up to $24,000 per year. Because of the tax breaks, it is worth contributing as much as possible.
Depending on the terms of a plan, employers may match all or part of the contributions you make. This is calculated using a matching formula. In most cases, they will either match all of your contributions up to a certain percentage of your salary, or they will match a percentage of your own contributions up to a Dollar limit.
Companies do not have to match employees contributions. The matching policy is part of the package they offer employees, and every company differs.
In some cases, you may forfeit some of the matching contributions if you leave the company before a certain time. Again, this differs from employer to employer, so read the terms of the fund.
Types of 401(k) Accounts
Target Date 401(k)
A target date retirement fund is designed to alter the mix of asset classes as an employee approaches retirement. Usually, an investor would do this themselves. When they are younger they will invest most of their retirement savings in stock funds. As they get older they would begin to invest more of their account in bond funds, to generate income and lower the volatility of the account. Target date funds have a specific target date and alter the mix of asset classes as that date approaches.
Roth 401(k) Accounts
In a traditional 401(k) account, the employee contributes to the fund without the contributions being taxed and then pays tax on the withdrawals. In a Roth 401(k), the contributions are taxed up front, meaning that all withdrawals are tax-free. Choosing between the two options comes down to comparing the tax rate at the time of contribution to your likely tax rate at the time of retirement. If your income is likely to grow during the course of your career then you may end up in a much higher tax bracket when you retire. In that case, it makes sense to pay the tax upfront at the lower rate – however, contributions are still capped at $18,000 even if they are already taxed.
Deciding on whether or not to use a Roth 401(k) deserves careful consideration. Before weighing up the options you need to find out whether you can convert your account from the post to pre-paid tax, whether you can actually afford to pay the tax upfront and whether you are likely to be in a higher or lower tax bracket when you retire. Some funds allow you to contribute partly to a traditional account and partly to a Roth account.
Rules for Withdrawals
You should familiarize yourself with the penalties you may incur if you withdraw money early. Firstly let’s look at the normal process for withdrawals.
When you turn 59.5 you may withdraw a lump sum or you may take periodic withdrawals. If you take a lump sum payment you will pay income tax, and your tax rate may be affected by that withdrawal.
Once you turn 70.5, you are required to start taking regular withdrawals. These have to be taken by the end of each year and the minimum amount will be based on your life expectancy. The objective is that you must withdraw the entire 401(k) account by the date you are expected to live until.
If you withdraw money before the age of 59.5 you will incur a 10% penalty unless you qualify for a hardship withdrawal. A hardship withdrawal may be used for medical expenses, costs related to a principal residence, to prevent an eviction or foreclosure, funeral expenses, college tuition for yourself, your spouse or dependents. Penalty-free free withdrawals are also permitted if you have a qualifying disability, you are required by court to pay alimony or if you leave a company and have a withdrawal schedule set up.
Managing your 401(k)
Some 401(k) plans allow investors to direct their accounts themselves. There are pros and cons to making 401(k) investments yourself. The advantage is that you will have far more potential investments to choose from and you can tailor a portfolio to suit your specific needs. A self-directed account allows you to invest in stocks and ETFs as well as mutual funds.
That’s fine if you know what you are doing and have some investment experience. But, for amateur investors, being given a huge array of choices can lead to overtrading and bad decision making. In any investment account, making changes costs money and eats into your profits.
Of course, you can also get a financial advisor to help you with a self-directed 401(k) accounts. This will give you the best of both worlds, provided the advisor is suitably experienced and qualified.