A great way to save money on a pre-tax basis is via a 401(k). And they are so handy because you can set it up and it comes out of your paycheck before you even see the money. It’s automated savings at its best. But they can also be very confusing and complicated. Below are two things you must know about your 401(k).
Set Up Automatic Increases When Possible
When employees contribute to their 401(k) plan, the money goes into the plan directly before the employee ever receives the money. It's easy to lose track of how much is being contributed. Too many times the initial contribution percentage is chosen arbitrarily and is not updated. Years can go by without any changes to the percentage that is being contributed. The IRS limits the amount you can contribute each year. If you are not contributing the maximum allowed, you should increase your contribution as much as you can afford as often as you can. The reality is that people get busy and forget. (For related reading, see: How to Get the Most Out of a 401(k) Program.)
Some employers now offer a feature in their 401(k)s called auto increase or auto escalation. With this option you choose your starting contribution rate, the annual increase percent and the target rate. Your 401(k) contribution will automatically increase by the chosen annual increase percent every year until the target rate is reached. This will help you to increase your savings without having to remember to do it every year. While, only 48% of employers offer plans with an auto-escalation feature, according to a 2014 survey by the Defined Contribution Institutional Investment Association, if you work for an employer whose 401(k) does offer it and you’re not maxing out your 401(k), sign up for the auto escalation feature.
Got a Roth 401(k)? Get a Roth IRA Also
If you are using a Roth 401(k) for your 401(k) contributions, you should also start a Roth IRA. Here’s why. Qualified distributions from a Roth 401(k) may be taken tax free. A withdrawal is considered qualified when it is made after you are age 59½ and a minimum of five years has gone by since January 1 of the year of the first contribution to the Roth 401(k) account.
Here's the catch. After you retire or otherwise leave the employer, if you rollover your Roth 401(k) to a Roth IRA, the time during which the assets were in the Roth 401(k) does not count toward the Roth IRA's five year holding period.
When you rollover your Roth 401(k) to a Roth IRA, the five-year holding period is never carried over. The Roth 401(k) money will be subject to the five-year rule for the Roth IRA. If the Roth IRA has already satisfied the five-year period, then the funds that were rolled over from the Roth 401(k) are deemed to have also met the five-year period, even if they were in the Roth 401(k) for only a year. However, you could have money in a Roth 401(k) for 20 years, leave your employer and rollover the Roth 401(k) to a newly-established Roth IRA and the five-year holding period will not have been met.
This is why if you choose to participate in a Roth 401(k), you should also consider establishing a Roth IRA as soon as possible, either through contributions or a conversion, if ineligible to contribute due to the income limits. (For more from this author, see: 8 Things to Do Before You Retire.)