401(k)s and other company plans are known as defined-contribution plans because you – as an employee – contribute to the plan, normally through regular payroll deductions. You decide how much to contribute (as a percentage of your salary), and contributions are automatically deducted from each paycheck.
The types of plans offered by employers depend upon the company’s or organization’s structure:
Contribution limits change periodically as the cost-of-living index increases. For tax year 2017, the IRS says you can contribute up to $18,000 to a 401(k), 403(b) or TSP, plus most 457 plans. If you are age 50 or over, you can make a catch-up contribution of $6,000 to any of these plans. These numbers are the same as for 2016.
If you’re lucky, your employer will add money to your account in the form of a matching contribution, which has the power to dramatically increase the value of your retirement account. If there is a company match, find out how much it is. It's common for employers to contribute a percentage of your contribution. Say you make $50,000 a year and contribute 5% of your salary ($2,500). If your company offers a 50% match, they’ll kick in another $1,250 to your account. Your employer’s contribution may be limited by the plan (for example, the plan may match 50% up to 4% of your salary), or by the annual contribution limit as set by the IRS.
Though the contribution is known, the benefit – how much money you will have at retirement – is unknown because it depends on the performance of the investments. You decide how to invest the money in your account, even if both you and your employer have made contributions. Typically, you’ll get to choose from a variety of investments offered by the plan, including mutual funds, stocks, bonds and guaranteed investment contracts (similar to certificates of deposit). If you don’t like the investment options, you may be able to transfer part of your plan to another retirement account, something known as a partial rollover.
When choosing investments, consider your risk tolerance and investment time horizon: As a general rule, you should invest more aggressively when you are younger (when you have more time to recover from any losses), and more conservatively as you approach retirement – so plan on changing your allocations over time. With most 401(k)s, you can make changes whenever you want, but some limit you to making changes only once a month or even once per quarter – ask your HR department for details.
It’s also important to consider expense ratios when choosing the investments in your 401(k). Investments like mutual funds and ETFs charge shareholders a fee (called an expense ratio) to cover the fund’s total annual operating expenses, including costs for administration, compliance, distribution, management, marketing, shareholder services, recordkeeping as well as other operational costs. The expense ratio directly reduces your returns – and the value of your investment. Don't assume an investment that reports the highest return is automatically the best choice. A lower-returning investment with a smaller expense ratio might make more money in the long run.
The money you contribute to a 401(k) is yours right away, but funds from matching contributions are not 100% yours until you are fully vested. Normally, funds vest over time: you might be 25% vested after one year of employment, for example, 50% vested after the second year and so on. Once you become fully vested, all the money in your 401(k) is yours – regardless of where it came from – and you can take it with you if you switch employers or retire.
In most cases, you’ll owe a 10% penalty tax if you make an early withdrawal from your 401(k) (or other qualified plan) before you are age 59½. Allowable exceptions to the 10% additional tax include:
Typically, you have to start taking distributions from your 401(k) by April 1 of the year after you turn 70½. After that, your required minimum distribution (RMD) – based on your life expectancy and the value of your account – has to be made by Dec. 31 each year. An exception to the RMD rules: If you continue to work, you can delay taking RMDs from your 401(k) until April 1 following the year you retire – unless you own more than 5% of the company that sponsors the plan. Then, you still have to start RMDs after you turn 70½, whether you continue to work or not.
Penalties for ignoring RMD rules are substantial: You’ll have to pay a 50% federal tax on any amount you should have withdrawn, plus your regular income taxes. The bottom line: Don’t ignore rules for RMDs.Exchange Traded Funds (ETFs)