How to Get the Most Out of Your 401(k) Plan

Grow and protect your nest egg with a workplace retirement plan

People are increasingly on their own when it comes to providing for their retirement. These days, traditional pensions, managed by the company one worked for, are all but unheard of outside of the civil service or heavily unionized industries. Furthermore, the pension's primary replacement, the 401(k) plan, transfers the saving and investing responsibility (and risk) to individual workers.

So, when it comes to the opportunities offered by employer-sponsored plans such as 401(k)s, it's vital that workers, savers, and investors—and you should see yourself as all three—make the most of them.

While the 401(k) has some differences compared to other plans, such as 403(b)s, most of the planning advice below applies across all the major plans in the United States, be they 401(k)s or individual retirement accounts (IRAs).

Key Takeaways

  • Consistent saving and compounding over time are keys to the successful growth of your retirement funds.
  • Always be sure to contribute enough to a 401(k) to qualify for matching contributions from your employer.
  • Be aware of the underlying costs and fees of the various investments within your retirement plan.
  • You can contribute to both a personal IRA and a 401(k) plan at work.
  • You may be able to choose either a 401(k) plan or a Roth 401(k) plan; each offers a particular tax advantage.

401(k) Contribution Limits

For employees who have the ambition and financial wherewithal to make the most of their 401(k), one of the best ways to begin is by working backward. Take your maximum allowable annual contribution, divide it by the number of pay periods in a year, and see where that leaves you.

For 2022, the maximum contribution limit for employees who participate in a 401(k), 403(b), most 457 plans, and the federal government's Thrift Savings Plan is increased to $20,500, up from $19,500 in 2021. There's also a catch-up contribution of $6,500 allowed if you're age 50 or older.

Your employer can contribute to your 401(k), too. For 2022, the combined annual limit (the sum of your own and your company's contributions) is $61,000, or $67,500 with the catch-up amount. That's up from $58,000/$64,500 in 2021.

Roth 401(k) vs. 401(k)

Your employer may offer you both a regular 401(k) and a Roth 401(k). The contribution limits are the same, but the Roth 401(k) is funded with after-tax dollars, like a Roth IRA.

Either 401(k) option is an important way to save for retirement. The Roth 401(k) provides taxpayers who earn too much to contribute to a Roth IRA the opportunity to gain the Roth IRA benefits of tax-free distributions and no required minimum distributions in your lifetime. Roth 401(k) money can later be rolled over into a Roth IRA.

A Roth 401(k), like a Roth IRA, provides savers with their tax break when they start taking withdrawals. Unlike a Roth IRA, it requires minimum distributions once savers turn age 72 unless they are still employed or have 5% ownership in the business associated with the 401(k).

Max Out Your 401(k)

Can you afford to save the maximum? If so, there is not much more you need to do to enhance your savings, apart from making the best investment decisions you can with the investment options provided by the plan.

If you cannot afford to contribute the maximum amount, whittle it down to what you can contribute. Clearly, expenses such as mortgage or rent payments, utilities, and food need to be covered. It makes little sense to put aside so much that you need to accumulate credit card debt to make it through a month.

Even if you cannot make the maximum contribution, consider supplementing whatever you can contribute with any bonuses or profit-sharing payments you receive.

Many companies allow you to have these amounts deposited directly into your 401(k). Such automatic deposits are a good idea because many good intentions have gone awry once a bonus check is in hand. 

Above all, try to be consistent with your savings. Set a specific per-paycheck amount and do not change it unless necessary. Likewise, do not try to time the market or curtail contributions because the economic or political news seems depressing.

If you can, try to save a minimum of 15% of your gross pay. This amount, coupled with reasonable investment returns on those savings, should be sufficient to supplement Social Security down the line and fund a comfortable retirement.

401(k) Employer Match

Fully exploiting an employer match is one of the most vital strategies for getting the most out of your 401(k) plan. Subject to specific rules and limits, your employer contributes the same amount of money you contribute, or a percentage thereof.

This effectively doubles your retirement savings without decreasing your salary or increasing your tax burden. Many employers match up to 3% of your pay—so try as hard as you can to get at least that amount.

Want another reason to max out your employer match? In many cases, employers calculate their costs and base their staffers’ salaries on full matching. If you don’t take advantage of this, you’re handing back free money.

Some employers elect to match your contributions in company stock. While this is not always as desirable as cash, it shouldn’t dissuade you from maximizing your match. Frequently, that stock can be sold and converted to cash within a reasonably short period of time and at a reasonable cost.

Required Minimum Distributions (RMDs)

As with some other retirement savings plans, 401(k)s have required minimum distributions. At age 72, 401(k) owners must start taking RMDs, whether they need the money or not. The IRS is serious about this. There's a 50% penalty for failing to withdraw the correct amount.

However, RMDs don't apply if an employee is still working for the same employer that sponsors the plan. Keep in mind that the funds in a Roth 401(k) can be rolled over to a Roth IRA which has no required minimum distributions during the owner's lifetime.

Owners did not have to take RMDs in 2020, following the March 2020 passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which temporarily waived distribution requirements for IRAs and other retirement plans. The Act doesn't impact Roth IRAs, which don't require withdrawals until after the owner's death.

401(k) Vesting

An employer may require a certain number of years of service before its matching contributions belong to the employee. This is called a vesting schedule. In general, there are two types of 401(k) vesting schedules:

  • Cliff vesting refers to an employee going from owning 0% of matching contributions to 100% ownership after a specific amount of time.
  • Graduated vesting refers to an employee owning an increasing portion of the matching contributions until they eventually own them all.

The U.S. Department of Labor requires full vesting after six years of service. Still, to get the most out of a 401(k) and the employer match, it's essential to understand a plan's vesting schedule. That's because the company could take back some or all of its matching contributions if an employee leaves before being fully vested.

401(k) Fees

Investment Advice

As part of some employee retirement plans, workers can avail themselves of investment advice from independent professionals. Unfortunately, this advice is rarely free, and you may find that you pay 1% to 2% of your funds to get this help.

Understandably, many workers feel overwhelmed when it comes to calculating their contributions and then investing that money. Some will want help mainly due to a relatively fixed menu of investment options. Just bear in mind that paying for investment advice reduces your account's value and capacity for growth so, consider it carefully.

Investment Expenses

Savers also need to pay careful attention to the costs of the investments they hold within their 401(k). In general, mutual fund expenses have come down over the years, and many fund families offer no-load funds for 401(k) plans as well as low-cost index funds. Of course, it’s essential to compare and contrast the numbers because fees still vary a good deal.

Along similar lines, investors need to be careful with financial savings tools like annuities and target-date funds. Annuities arguably do not have much of a place in tax-sheltered accounts to begin with. What's more, their often high expense ratios can eat away at their value over time.

Likewise, while target-date funds are popular options in many plans, they often (but not always) charge higher fees than regular funds, without correspondingly better results.

The 401(k) is a workplace retirement savings plan with tax benefits. It allows employees to contribute funds from their paychecks up to a certain annual amount on a regular basis throughout their working years. Often, employers will match part of an employee's contribution with their own, boosting the amount saved. The savings and earnings in a traditional 401(k) grow tax deferred until withdrawn. Those in a Roth 401(k) can be withdrawn tax free.

401(k) Loans

Workers who save some funds in a 401(k) but find they cannot contribute more because they are saddled with expensive debt may be able to take a loan from their 401(k)s.

Most plans have provisions that allow employees to borrow funds from their accounts. This money comes relatively free of strings insofar as what the funds can be used for. For example, it's possible to use savings to pay off high-interest loans or credit card balances. This money does not come free of charge. However, the good news is that the interest you'll pay goes to your account.

A 401(k) loan is not a risk-free maneuver. The money has to be repaid on time, or the borrower will incur penalties. Moreover, some workers will find that borrowing from their retirement savings is just a little too convenient, and opens a Pandora’s box of future savings trouble.

Nevertheless, this can be an effective way to free up more money for savings. It is not for everyone. Nonetheless, borrowing low-cost cash from a 401(k) to repay high-cost credit card debt and ultimately invest even more in the 401(k) can be a prudent choice.

401(k) Problems

If you do not like how a plan is organized or the investment options on offer, say so. Complaining about a deficient plan can be an effective means of improving a plan's investment choices.

Keep in mind that many employers choose 401(k) plans on the basis of what is cheapest and most convenient to offer. They may not even be aware of its deficiencies.

While it is true that many workers do not like to be a squeaky wheel, doing nothing is a pretty good way to ensure that the plan will not be improved. Some companies are undoubtedly apt to be more responsive than others.

Traditional and Roth IRAs

What do you do if you have maxed out your 401(k) but want to save even more? Thankfully, there are options available to you, including traditional IRAs and Roth IRAs.

You can contribute up to $6,000 to either type of IRA in 2022. If you're age 50 or older, you can add a $1,000 catch-up contribution.

Traditional IRAs and 401(k)s are funded with pre-tax contributions. You get an upfront tax deduction and pay taxes on withdrawals in retirement. The Roth IRA and Roth 401(k) are funded with after-tax dollars. That means you don't get an upfront tax break, but qualified distributions in retirement are tax-free.

If you or your spouse is covered by a retirement plan at work—such as a 401(k)—the tax deduction for your traditional IRA contributions will be limited. With Roth IRAs, the amount you may contribute will be limited by the amount of your annual earnings.

Annuities and Health Savings Accounts

There are other tax-advantaged ways to save after you have maxed out an IRA and 401(k) account. One option is to consider buying and investing in annuities.

Annuities have many advantages and disadvantages. They can carry high sales loads, typically have high expenses, and sponsors have continually transferred more risk to the investor.

That said, money in an annuity can accumulate without year-to-year taxation. It may be a worthwhile option if protecting even more retirement savings from the taxman is essential.

If you have a high-deductible health plan (HDHP), another savings option is a Health Savings Account (HSA). It's a tax-advantaged vehicle you can use with certain types of health insurance.

Many investors, particularly higher-income families that can afford to pay the deductibles and young employees in good health, find these accounts helpful for saving additional retirement funds.

What Is a 401(k) Plan?

It's a workplace retirement plan offered by many, but not all, employers. It facilitates ongoing saving and investing by employees and helps them gradually build the funds they'll need for their retirement years. Often, employers make contributions to the accounts of employees. So, it's a great savings option that working Americans should do their utmost to take advantage of.

What Happens to My 401(k) Savings If I Leave One Job for Another?

Typically, you have several options. You may be able to leave your savings where they are (if they're above a certain amount). You may be able to bring your 401(k) savings from your old job to your new one (without paying taxes). You could move your workplace savings into a rollover IRA, a personal IRA created to house workplace retirement plan savings. One last option is to cash out your plan but this isn't usually recommended. You'll pay taxes and perhaps a penalty if you're less than age 591/2. Plus, your money will no longer be working for you.

Can I Roll Funds From a Traditional 401(k) Into a Roth IRA?

Yes, you can. However, you'll owe taxes on the 401(k) savings for the year in which you roll them into the Roth. That's because you got the upfront tax deduction on your contributions with the proviso that you'd pay taxes on withdrawals. However, you'll pay no taxes on your future withdrawals from the Roth IRA. It's a good idea to inform yourself completely of the rules concerning such a rollover so you can be sure to protect your savings.

The Bottom Line

Tax-advantaged retirement savings plans are one of the relatively few tax breaks that the government gives to ordinary workers. Careful saving may not necessarily be a gateway to becoming independently wealthy but it can go a long way toward ensuring a more comfortable and pleasant retirement.

Whatever the specifics on offer to you, be it a 401(k), a 403(b), or an IRA, make sure to contribute as much as you can afford and take full advantage of your opportunity to put money away for the future.

Article Sources
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