Workers who are funding their retirement through an employer’s qualified plan often run the risk of developing tunnel vision where their 401(k) benefits are concerned. Either they only save the minimum, or, worse, they don't save at all. (For more, see The Basics of a 401(k) Retirement Plan.)
According to Deloitte’s Annual Defined Contribution Benchmarking Survey, 75% of employees on average participated in their employer’s plan in 2015. And 34% of employers said that when their employees didn’t participate, the number-one reason was a lack of understanding about how the plan works.
Not only are savers not reaping the savings benefits of their plans; they could also be missing out on certain features that other retirement accounts may not afford. If you have access to a 401(k) plan, here’s what you should be paying attention to.
These factors also provide additional reasons why you shouldn't be afraid of saving the most you can. (For more, see 4 Ways to Maximize Your 401(k).)
Contributing to a 401(k) is important for your retirement well-being, so understanding how to leverage it in your favor is important. The following four benefits can help you get more from your plan, but they often go unnoticed.
1. Step-Up Contributions
Periodically increasing your elective salary deferrals is a relatively hassle-free way to boost your retirement savings. For example, you can set your plan to increase your contributions automatically by 1% each year. According to the Deloitte study, 62% of plans offered step-up contributions in 2015, either automatically or as an elective feature. Surprisingly, however, only 7% of employers said that more than 50% of their employees were actively using it.
If you’re looking for a way to increase your savings without having to make a major dent in your take-home pay, step-up contributions are a good solution. If you get a 2% raise each year, for instance, committing half of that to your 401(k) allows you to save more while still seeing a bump in your paycheck. (For more, see 5 Things to Request If You Can’t Get a Raise.)
2. 401(k) Loans for Home Purchases
The Internal Revenue Service (IRS) allows you to borrow up to 50% of your vested balance in a 401(k), to a maximum of $50,000. Generally, that money has to be paid back within five years, or at your separation date if you leave your job before the five years is up. If you’re using that money toward a home purchase, however, the five-year rule is a little more flexible.
For instance, your employer may give you 10 or 15 years to pay back a 401(k) loan associated with a home purchase. Another advantage of using a 401(k) versus tapping an Individual Retirement Account (IRA) is the amount you can withdraw. The most you can pull out of an IRA without paying a penalty is $10,000. If you’ve been saving steadily in your 401(k), you may have significantly more cash on which to draw.
3. Roth 401(k) Option
Generally, the money you contribute to a 401(k) is taxable once you begin taking distributions in retirement. If you choose a Roth designation, those withdrawals would become tax free. According to Vanguard’s How America Saves 2016 report, 60% of 401(k) plans offer a Roth option. If you’re concerned about your tax liability potentially increasing in retirement, going the Roth route could cut down on what you owe to Uncle Sam.
4. Hardship Withdrawals
Whether you should take advantage of this fourth benefit is a matter of debate. It's best to keep your retirement savings where they are. But compared to other sources of cash in a true pinch, a 401(k) can be the more cost-effective choice. And you're likely to have it. A massive 84% of 401(k) plans allow employees to take some form of hardship withdrawal, according to Vanguard. The data show that only approximately 3% of workers ever use that feature.
While a hardship withdrawal isn’t necessarily the best substitute for a sizable emergency fund, pulling cash out of your retirement account may be preferable to running up credit card debt or drawing on your home equity. (For more, see When a 401(k) Hardship Withdrawal Makes Sense.)
Here’s a good way to determine whether raiding your 401(k) makes sense when you’re in a bind. Hardship withdrawals are subject to regular income tax and a 10% early withdrawal penalty if you’re under age 59½. Compare what you’d owe in taxes to how much a credit card or loan would cost you in interest over the long term to see which one ends up being the more affordable choice.
A 401(k) is a powerful tool for creating a solid financial platform for your retirement. Saving too little out of fear that you won't have spare cash in an emergency is shortchanging yourself. Spending some time digging into the finer points of your plan can help you formulate a strategy for getting the most out of your 401(k) in the long run.