In many cases there is a lack of understanding when it comes to 401(k)s by employees, employers and sometimes even 401(k) plan administrators.
Luckily, the important aspects of these plans are fairly simple to explain. If you can gain a basic understanding of just a few of the key features of your 401(k) plan, you will have the ability to make more informed financial decisions and greatly enhance your future financial stability.
401(k)s Are Tax-Deferred
After FICA taxes, the money you contribute to your 401(k) is taken out of your paycheck before the rest is hit with income tax and passed along to you. The funds in the 401(k) can then be invested in the market to grow over your lifetime.
Shortly after you reach age 70 you will be required to start taking withdrawals from the account each year. Those required withdrawals, called required minimum distributions, will be taxed as ordinary income.
There are two major benefits to deferring the payment of tax until later in life. One is you will likely be in a lower tax bracket at age 70 than you were during the years while you were making contributions to the 401(k). The other is that your taxable income is lowered each year you contribute to your 401(k).
In Many Cases, Participating Will Earn You Free Money
Many employer-sponsored retirement plans offer participating employees a match on contributions, profit sharing or both. If your plan offers a match, your employer will match your contributions in some proportion up to some percentage of your pay. If your plan offers a profit-sharing component, your employer may, upon their discretion, contribute company money on your behalf as a profit-sharing contribution. Both of these plan features are free money and you are crazy not take advantage of them. (For related reading, see: How to Get the Most out of a 401(k) Program.)
Your Contributions Are Always Vested
The concept of vesting seems to cause a lot of confusion, but it’s actually fairly simple. The money you contribute to your 401(k) as a salary deferral, as well as the earnings on that money, is always yours from the minute you contribute it. If you leave employment at any time, that money will remain yours and can be moved out of your 401(k) to a new 401(k), an IRA Rollover or mailed to you in a check. Employer contributions to your 401(k), such as matching and profit-sharing contributions, typically vest on some sort of schedule. If you leave employment before you are fully vested, then either a portion or all of the employer contributions will no longer be yours.
It Is Not a Piggy Bank
A common mistake is looking to your 401(k) to solve your financial problems in a pinch. While it may be the best solution in some limited circumstances, it frequently is not, and there are many overlooked pitfalls to using your 401(k) as a piggy bank.
401(k) loans are enticing because people like to focus on the fact you are borrowing money from your own nest egg rather than from a third party. However, there are quite a few downsides to 401(k) loans that many people fail to consider. First is the fact that you repay the loan with after-tax dollars. So, if you are in a 28% tax bracket, you must earn about $139 to make a $100 loan payment after taxes. There is also an opportunity cost to a 401(k) loan because you miss out on any compound growth your contributions would have benefited from had they stayed invested.
Early distributions are also problematic. When you leave employment, you have the option to roll your 401(k) over to a new retirement plan or IRA or take a distribution. If you choose to take a withdrawal, you will pay tax on the withdrawn funds and you will lose out on the future appreciation of your investments. Again, this is a big opportunity cost.
If you are under age 59.5, you will also pay a 10% penalty on the distribution. Why the penalty? Because these plans were designed to help you save for retirement, not purchase a house or a car.
If your employer offers a 401(k) plan, take some time to educate yourself on how the plan works and start participating if you aren’t already. The earlier you start, the better—but it’s never too late. (For related reading, see: Understanding 401(k)s and All Their Benefits.)