A 401(k) is a powerful tool to help you build wealth. To use it successfully you need to understand all of its working innards.
By now you probably know some basic characteristics of a 401(k). Your 401(k) is like a special holding cell for your wealth. To simplify things, you can look at this holding cell as having four specific properties.
- CONTRIBUTIONS -
- TAXES -
- INVESTING -
- WITHDRAWALS -
Understanding these four properties is vital to understanding what makes your 401(k) so great, and how to start using it to the fullest.
Anytime you put money into your 401(k) you’re making a Contribution. Typically contributions are set up as automatic, pre-tax deductions from your paycheck (more on this in the next section). This can easily be done online through your 401(k) plan administrator. How do you specify how much to contribute? Through your plan administrator’s website you can designate a percentage of your pre-tax income you’d like to contribute to your 401(k). 5% 10% 15%, whatever you’d like.
However, there are limits to how much money you can contribute to your 401(k). From the date of this writing in 2016, the maximum employee contribution was $18,000 per year. Visit the IRS website to see the latest contribution limits.
Your 401(k) may also come with a contribution from your employer. This is typically in the form of an employer “match” of your own contribution up to a certain amount or percentage. For example, your employer may match your personal contribution up to 5% of your salary if you also contribute 5%.
This “free money” is a huge incentive for savers and makes the 401(k) unique compared to other wealth growing tools.
There are many nay-sayers out there who bash on 401(k)s and say you should skip them altogether. While they may not be for everyone, I can’t think of a reason to not get at least the full match from your employer.
The employer match doesn’t work against your personal contribution limit of $18,000. The combined employee/employer contribution for 2016 is $53,000.
Another unique attribute of the 401(k) is your contributions are tax-deferred, meaning instead of paying taxes on those dollars now, you won’t pay taxes on them until you take the money out of your 401(k).
So assuming you’re in a 25% income tax bracket, each dollar you contribute to your 401(k) goes fully into your 401(k). If the dollar was taxed before going into your 401(k), you would only have 75 cents to invest. This makes a huge difference over a long period of time. The more of each dollar you have working for you, the better.
The idea of postponing the payment of taxes until later may make sense to a lot of investors. Many assume they will be in a lower tax bracket when they begin withdrawing funds from their 401(k) in the future, since their income will be lower. Postponing a 25% tax to pay a 15% tax later seems like a good bargain, however, this is making the assumption that taxes will not increase in the future.
Another benefit is your earnings are not taxed as your investments increase in value. Even when investments are bought, sold, and then bought again within your 401(k), as long as the funds stay within your 401(k) you do not pay taxes on any of the money you have earned. Taxes are only paid when withdrawals begin which in most cases can begin as early as 59 ½.
Once you’ve begun your 401(k) contributions, they can be put into a specific type of investment. This is an important distinction. Sometimes investors think that having a 401(k) means they are invested in the market. Remember, the 401(k) is just the special holding cell. Once your money is there, you still need to do something with it.
401(k)s typically have a wide variety of investment options which can be overwhelming. In my experience, most 401(k) plans have 20 to 30 different investments to choose from. Because of this it can be tricky understanding which investments are right for you.
We’ll go into great detail in other articles of what to think about when selecting your 401(k) investments. For now, we’ll just cover the basics.
One of the things that makes 401(k)s so easy to use is investing can be automated. So not only can your contributions (money from your paycheck) go into your account automatically, but those dollars can be allocated to the appropriate investments automatically as well.
Mutual Funds and Index Funds make up most investment selections within a 401(k).
A Mutual Fund is a collection of different securities, like stocks or bonds, based on a certain investment class or investment objective. For example, a mutual fund might be designed to target a 60/40 combination of stocks and bonds. Another might only invest in the stock of health care companies.
Mutual Funds can hold millions of stock shares or bonds from thousands of different companies. Investing in a Mutual Fund allows you to buy shares of the fund, which is like purchasing small slices of each of the many investments within the fund. The beauty of this is the diversifying effect that is created by spreading your dollars across a wide variety of investments without having to spend the time and cost of purchasing each one.
All Mutual Funds will carry management fees which are charged to pay the cost of administering the fund. These typically range from 0.50 to 1.50% depending on factors like how often stocks are traded into or out of a particular Mutual Fund.
An Index Fund is also a collection of securities, but instead of these matching a particular investment class or objective they simply track an index, which is a way of measuring the value of a particular section of the overall market.
For instance, the well-known S&P 500 Index tracks the 500 largest U.S. based companies. If overall these companies go up in value, the value of the index goes up too. Investing in an Index Fund that tracks the S&P 500 index means the performance of the Index Fund is very closely tied to the performance of the actual index.
Index Funds carry management fees as well, sometimes as low as 0.05 to 0.20%. Why is there such a big difference compared to Mutual Fund fees? This is typically because the cost of administering an Index Fund is lower than that of a Mutual Fund, since the Index Fund management team simply needs to choose investments based on an existing index, rather than doing extra research to find the right stock or bond for their Mutual Fund.
Some employers have a predetermined fund or group of funds ready for your money to go into when you open your 401(k). You can stick with this, or you can select investments that may be better suited for you based on your tolerance for risk and goals. If you don’t feel confident making your own investment selections, you can ask your 401(k) plan administrator or a financial advisor for some guidance.
401(k)s were created by the federal tax code to help you save for retirement. Because of this there are limits to when you can tap into them. In theory, withdrawals from your 401(k) can happen anytime, however, in most cases you will be penalized for an early withdrawal, meaning the withdrawal occurs before the age 59 ½. This penalty is a hefty 10% of the amount withdrawn.
What happens when you leave your employer and you have an old 401(k) that you’d like to bring with you to your new job? Isn’t this also considered an early withdrawal?
Simply moving an old 401(k) elsewhere doesn’t mean it counts as an early withdrawal. For instance, you could move your old 401(k) into a Rollover IRA. As long as this is done within 60 days you won’t be penalized. You may also be able to move your old 401(k) plan into a new 401(k) plan. Check with your 401(k) plan administrator to get details on how this is done.
The biggest thing to remember is that if you withdraw funds from your 401(k) account prior to age 59 ½ and you don’t move them into 1) a new 401(k) or 2) a new or existing Rollover IRA you will likely need to pay taxes on the withdrawal and a 10% penalty. The government doesn’t like you reaping the rewards of your 401(k) too early (and neither should you).
On the other hand, the government doesn’t want your withdrawals happening too late either. Remember, you still owe them taxes on your contributions and growth!
Once you reach the age of 70 ½ Minimum Required Distributions, or MRDs are required. You can always take more than the minimum amount, but the minimum must be taken to avoid penalties, which can be very steep. To get help calculating your MRD, explore Fidelity’s MRD calculator.
Here are some main takeaways:
- Can be automated directly from your paycheck
- Your personal contributions can be up to $18,000 each year
- An employer match is free money and should rarely be passed up
- 401(k) contributions are pre-tax, allowing more of each dollar to work and grow
- You owe taxes once you begin 401(k) withdrawals, hopefully in a lower tax bracket
- Like contributions, investments can be automated as well
- 401(k) investments tend to be made up of Mutual Funds and Index Funds
- You can select the investments within your 401(k) or let your employer do it for you
- Moving money out of your 401(k) does not necessarily create an early withdrawal penalty
- Minimum required distributions from your 401(k) begin at age 70 ½