Apply for a job, and your potential employer will tell you about the salary, the promotion prospects, and the health benefits. They’ll also boast about the company’s 401(k) plan. For a young jobseeker, that benefit might sound dubious. It’s money that will leave their pay packet before it reaches them and disappear before they can spend it.
A 401k can sound like a piece of employment bureaucracy that employers offer and employees endure.
In fact, a 401(k) is important. It’s a vital part of a company’s employment package and it will play an essential role in the employee’s life—both when they’re working and when they stop working. In this guide, we’ll explain everything you need to know about the 401(k).
What Is a 401(k)?
A 401(k) is a kind of retirement fund. The strange name comes from the section of the US Internal Revenue Code that determines the 401(k)’s tax benefits. It’s use a retirement fund was unintended.
In 1978, Congress passed a Revenue Act that included a section enabling employees to defer tax on deferred compensation. Section 401(k) meant that if a company agreed to pay an employee a sum of money but would only give that amount to the employee in the future, the employee wouldn’t be liable for tax on that amount until they received it.
It took a couple of years before benefits consultant Ted Benna saw the opportunity to use the section to create a tax-friendly retirement program for a client. Employees would put money into a fund, and receive a matching amount from the client. Because the employer’s contribution was deferred, the employee wouldn’t have to pay tax on it until they made a withdrawal from the fund.
A year later, the IRS made the idea official by issuing new rules. Employees could now fund their 401(k) directly from payroll deductions. In effect, they could receive a tax deferment on both their own contributions and the employer contributions. By 1983, almost half of all large companies had either implemented a 401(k) plan or were thinking about it.
How a 401k Plan Works
Unlike their other savings plans, employees make contributions to their 401(k)s directly from their salaries. Their employers can make matching contributions.
So a 401(k) will reduce the amount you see on the bottom line of your pay slip by putting money aside for your retirement. It will also deliver tax advantages. Depending on the type of 401(k) you’re using, you’ll either pay your taxes before investing in the 401(k) but not have to pay tax when you withdraw the funds. Or you’ll put money in the 401(k) before paying tax but you’ll have to pay taxes when you retire and make withdrawals.
Because employers deduct 401(k) payments directly from salaries, you won’t notice the money coming out of your pay slip and moving into your 401(k). The danger, though, is that you also won’t notice the money your employer can add to that fund. That’s extra income that you can miss if you’re only looking at the bottom line.
401(k) contributions might not be pay that you can spend right now but it can boost your income. It’s money that you will be able to spend in the future—and because of the tax benefits, it can be worth a lot more when you receive it.
401k Contribution Limits
There are limits on the amount that you can contribute. Employees can contribute up to $19,500 a year. People aged 50 or older can add another $6,500 to top up their funds. Employers can match those contributions until the total payments reach $58,000, or $64,500 including top-up funds.
Any withdrawals made from a 401(k) plan before the age of 59.5 will incur a penalty of 10 percent in addition to income tax. Like most retirement plans, pulling funds early from a 401(k) plan is expensive and best avoided.
But 401(k) plans can also have vesting conditions. Employees may only be able to access their employer contributions after they’ve worked at a company for a pre-defined period of time. In effect, a 401(k)’s vesting plan helps to keep an employee at a business or risk losing some of their expected retirement payments.
The Difference Between a 401(k) and a Pension
A 401(k) is a type of retirement plan, but it’s not a traditional pension plan.
A traditional pension plan has defined benefits. The beneficiary of a pension plan (and their employer) puts money each month into the pension fund. That fund grows over the years. Eventually, the employee reaches retirement age and the fund starts to make payments.
Those pension payments will be the same regardless of how well the fund has performed. If the fund hasn’t grown enough to make those payments, the employer is responsible for making up the difference.
It’s a commitment that companies are now less willing to accept. Few institutions outside the public sector now offer pensions with defined and guaranteed benefits.
Instead, they’re moving to defined contribution plans such as 401(k)s. Each month, the employee (and the company) put a set amount of money into the fund. The amount that the fund pays out on retirement will depend on the performance of the fund. If the markets haven’t performed well, the payouts may be lower than the retiree expects.
On the other hand, if the fund and the markets have performed well, the retiree could have a higher income than they anticipated.
Defined contribution plans remove the commitment from the employer and leave retirees uncertain of the amount they’ll receive when they stop working.
The Benefits of a 401k
The goal of a 401(k), like any retirement plan, is to ensure that workers save money for the future. It forces workers to put money aside so that they’ll have funds when they retire.
To encourage people to put aside money that they’d probably like to spend now, the government offers tax benefits for funds paid into a 401(k). So if you’re earning a high income now—and paying a high rate of tax—but you expect that your tax rate will be lower after you’ve retired, then your 401(k) can save you a significant amount of money.
Someone paying the top rate of income tax might be able to spare putting $19,000 into their 401(k) each year, for example. Instead of giving 37 percent of that amount to the government in income tax, they could put into their 401(k) and they may only have to give 10 percent to the IRS when their take it out. They’re have saved more than $5,000 each year.
401(k) plans also have employer matching contributions. As we’ll see, those contributions don’t have to be one-to-one but they do provide important extra income that you can use in the future.
Four Alternative 401(k) Plans
It was a small tweak to one section of a larger tax bill that accidentally created the 401(k) plan, but those new rules weren’t the last changes.
In addition to the “traditional 401(k) plan,” there are now a small number of variations.
Roth 401(k) Plans
The most common variation is a Roth 401(k) Plan. Named after Delaware’s Senator William Roth, who was the primary sponsor of the 1997 legislation that created the Roth IRA, the plans adjust the taxes on 401(k) plans.
A traditional 401(k) plan allows employees to defer taxes on a part of their income until retirement. For most people, that’s beneficial. Usually, people have lower incomes after they retire than they did when they were working. That will allow them to collect their contributions at a lower tax rate.
But tax rates change and so do life circumstances. If you expect that your taxes will rise before you retire or if you think that your income will be higher in the future than it is now, you might prefer to pay your income tax sooner rather than later.
A Roth 401(k) plan lets employees use after-tax dollars to fund their plan. They pay tax on the contribution but the payouts they receive after retirement are tax-free.
Roth 401(k) plans are less common than traditional 401(k)s. Fewer people expect to earn more in retirement than they earned while they were working so not all companies offer them. When companies do offer them, less than half of employees accept them.
Those employees are likely to be hedging their bets. Employees don’t always have to choose between a traditional 401(k) plan or a Roth 401(k) plan. They can choose both, and put some money in each.
That allows them to benefit from some tax deferment while also protecting themselves against future tax rises. If taxes are currently relatively low, you might want to benefit from those rates now before the next administration puts them up.
401(k) plans offer clear benefits to employees. But not all taxpayers are employees; almost 60 million Americans now work as freelancers. They don’t have employers and they’re entirely dependent on their own efforts to ensure that they fund their retirement plans.
Solo 401(k) plans are for freelancers, the self-employed, and independent contractors. If you don’t employ anyone but yourself (or your spouse), and you do have earned income, then you can create a Solo 401(k) plan.
Like an employer’s 401(k) plan, Solo 401(k) plans also come in traditional and Roth forms. You can still choose to defer your taxes until you make your withdrawals or pay the taxes now and take the withdrawals tax-free.
Setting up the Solo 401(k) plan, though, can be a little complex. The IRS requires a written declaration of the kind of plan you want to set up. That’s something you’ll probably want to do with your accountant or tax advisor.
But it’s worth doing if only because a 401(k) has particularly high contribution limits. Because a freelancer is both an employer and an employee they can make tax-deferred contributions from sides. However high their income, they can still squirrel away as much as $58,000 (or $64,500 if they’re over 50) a year on a tax-deferred basis.
It’s also possible to borrow money from a Solo 401(k) plan. While borrowing your retirement money is usually a bad strategy, it can be a useful option if you really need it.
Setting up a 401(k) isn’t always straightforward for small businesses. Like any tax plan, there’s bureaucracy to manage. In particular, retirement plans have to show that they can meet the IRS’s non-discrimination rule. This requires everyone in the company to receive the same retirement plan benefits. An entry-level employee must receive the same employer contributions, the same tax breaks, and the same investment options as a vice president or chief executive. Showing that a 401(k) plan obeys the non-discrimination rule usually means hiring accountants or tax advisors. It can be expensive.
401(k) plans also require business owners to make some difficult decisions. How much vesting time should they include in their 401(k) plans? How much should they contribute as an employer? Should they contribute anything at all?
A SIMPLE 401(k) supplies a basic 401(k) plan that small businesses can use to get up and running. The name of the plan stands for Savings Incentive Match Plan for Employees of Small Employers. It’s available to firms that employ no more than 100 people.
The employees who benefit from the plan have to be 21 years old or older, have earned at least $5,000 the previous year, and they need to have been with the company for at least twelve months.
What’s in a SIMPLE 401(k)?
What the company can offer if it meets those qualifications is a kind of mini-401(k). It doesn’t have to show that it meets the non-discrimination rule; with fewer than 100 employees, any differences won’t have a large effect. Contributor limits are lower. An employee can currently pay no more than $13,500 into the fund, and workers over 50 can only top up their contributions by up to $3,000.
The employer must make a matching contribution of up to 3 percent of an employee’s pay. If any employees choose not to contribute to the SIMPLE 401(k) themselves, the employer must still put an amount equal to 2 percent of each eligible employee’s pay into the fund.
Contributions also vest immediately. Use a SIMPLE 401(k) plan and your employees will suffer no penalty to their pensions if they leave the company after a year or two. Unlike many other retirement plans, employees can also take out loans against contributions to their SIMPLE 401(k)s.
So this kind of 401(k) plan can be a good option for small businesses. But it’s not perfect. There’s still a fair amount of paperwork to complete. The business needs to file Form 5500 and issue deferral notices to each eligible employee every year. There’s little flexibility in the employer contributions, and immediate vesting makes it harder to hold onto staff. Companies that use a SIMPLE 401(k) are also prohibited from using any other kind of retirement fund.
But a SIMPLE 401(k) does get a small business up and running with a retirement fund. It enables even small companies to compete with the benefits of large rivals and show that they’re committed to helping their employees plan for their future. It also shows that the company sees its employees remaining with them all the way through to retirement.
Multiple Employer 401(k)s
Even SIMPLE 401(k)s require some organization and some accounting expenses. One way to share the load is to join up with other small businesses tackling the same problem.
At the end of September 2019, the Department of Labor interpreted existing rules to provide new guidelines that govern how businesses can form Association Retirement Plans, or ARPs.
ARPs are a new kind of multiple employer plan. Previous multiple employer plans required members to have something in common. The companies in the plan needed to be part of the same corporate group or be members of a trade association. The new rule expands the common characteristic to include a geographic region or an industry. It allows organizations such as a local chamber of commerce or a trade group to offer a 401(k) on behalf of their members.
So a café owner who wanted to give their employees the benefits of a 401(k) without the hassle and expense of setting up one up themselves could join the local chamber of commerce. If that chamber offers a 401(k) plan, the café could contribute to it and enroll its employees.
Alternatively, the café owner could team up with the owners of other cafés—either locally or more broadly—to set up a trade association. One of the benefits of that trade association would be a 401(k) for members’ employees.
The rules require the association to have a connection beyond the 401(k) itself, so if you’re thinking of setting one up, ask what else members can offer. If you want to join an association for the 401(k) alone, you might be better off looking for a chamber of commerce or other trade association that already offers a 401(k) plan.
How Employers Should Choose a 401(k)
So employers have a number of different choices of 401(k) plans that they could offer their employees. The best way to make that decision is to consult with their accountant or tax advisor but a number of factors will determine their choice:
Large businesses don’t need to consider SIMPLE 401(k) plans. Multiple Employer plans are unlikely to suit them either. Companies that aren’t eligible for particular kinds of plan will have fewer choices.
One of the choices that companies offering a 401(k) plan will need to make is whether to offer a Roth 401(k) or a traditional 401(k). Should they let employees pay taxes before making their contribution? Or should they allow them to defer their taxes until they start receiving their payouts? Or should they do both?
One factor that will weigh on that decision will be the salary levels at the company. A company with young, low-paid staff might prefer to offer a Roth 401(k). Their staff will be able to pay their taxes at their current low rates before their income—and their marginal tax rate—rises.
A 401(k) plan is a benefit that a company offers to attract and serve its employees. The attractiveness of that benefit will depend on what other companies are offering. Part of the process of creating a 401(k) plan will be looking at the 401(k) plans at similar companies competing for the same pool of potential employees.
That research will include listing the types of 401(k) plan available but also at the degree of matching contribution and the vesting time.
Cost and Complexity
Finally, while setting up some sort of retirement plan will be essential whether you work for yourself or own a small business, that plan will cost money. It will add to the cost of your employees and it will mean filing additional paperwork. The more complex the plans you offer, and the bigger the contributions you want to make, the more work and expense the plans will involve.
And, of course, once you’ve decided which types of 401(k) plans you want to offer you’ll still need to choose the funds in which you want to make the investments.
5 Questions Employees Should Ask Before Choosing a 401(k)
Employees will have fewer decisions to make about their 401(k) but they’ll still need to do a little thinking before they decide whether to opt for a Roth (401)k or a traditional 401(k). High salary earners, for example, will look more kindly on traditional 401(k) plans that let them defer their taxes than on Roth 401(k)s that levy taxes on the value of their contributions now.
At large companies, the HR department should be able to provide some guidance but you should go into the meeting armed with a number of questions.
How Much Will the Company Contribute?
Employees have very little control over the amount the company pays them. They might be able to boost their salaries by winning bonuses or by working extra hours but the usual way to increase a salary is to ask for a raise.
That’s never fun, and it doesn’t always yield results.
But once you know how much your employer will contribute to your 401(k) in matching contributions, you can control how much extra the company puts in your retirement fund.
If your company matches your contributions on a 50 percent basis, for example, and you plan to contribute $10,000 a year, you’ll add $5,000 to your overall income.
That gives you a big incentive to put as much into your 401(k) plan as possible. Contribute the maximum of $19,500 and you’ll have increased your salary by $9,750. It also means that whatever the level of matching contribution, failing to put the maximum into your 401(k) plan will be a way of cutting your own income.
In practice, companies rarely offer one-to-one contributions (or even one-to-two contributions) and they cap the amount they’ll pay. But when the company starts listing its pay and benefits, be sure to ask about the matching contributions. You’ll be able to see how much you’ll be leaving on the table if you don’t contribute everything you can to your 401(k) plan.
Where Are the Funds Invested?
One reason that you might want to contribute less than the maximum amount to your 401(k) plan is the performance of the retirement fund itself. Investing in a retirement fund means trusting institutional investors to put your money where it will do the best.
But the company’s fund might not be the best available. It’s results might be weaker than the market average. If the company has chosen a poor retirement fund then you might be better off keeping the money and investing it somewhere else.
In practice, though, that’s going to be difficult to justify. The loss of tax advantages and any matching contribution is likely to outweigh any advantage gained by putting your money in a higher-performing fund. But you should still know how well your fund is performing and track its performance if only to know how much you can expect to receive after you retire.
How Long is the Vesting?
The contributions that you make to your 401(k) will always be yours. But the matching contributions that the company makes to your 401(k) may never become yours. 401(k) plans allow companies to apply vesting conditions. In order to obtain the matching contributions, the employer will need to have remained with the company for a certain period of time. That vesting can come in two forms:
Cliff Vesting is an all-or-nothing arrangement. Until you’ve met the threshold, you’ll receive none of the matching contributions. Beyond the threshold, you’ll receive all of the contributions. It’s a strategy that helps to ensure that the employee remains with the company for a minimum period of time on pain of a significant financial loss. It can be useful for companies that invest in employee training. If the firm is going to expend resources on an employee, then Cliff Vesting allows it to recoup some of its expenditure if the worker leaves before giving the company the value of that investment.
Graded Vesting matches the amount of matching contribution to the time spent at the company. An employee who leaves after completing just 10 percent of their vesting time, might receive 10 percent of the matching contribution, for example. At 50 percent, they receive half. Once they’ve met the vesting requirements, they can leave at any time and take all of their matching contributions with them.
This is a much more flexible form of vesting. While it still incentivizes employees to remain with the company, it does allow them to keep at least some of their matching contributions if they leave early. It’s a useful tool for a company to have when competition for employees is tight.
And it’s also useful for employees to know so that they can understand exactly how much they’ll lose if they leave the company.
Whether the firm uses Cliff Vesting or Graded Vesting, employees should ask about vesting times, and know how long they need to stay at the company to keep all of their matching contributions.
What are Distribution Conditions?
Usually 401(k) plans come with a penalty clause. Pull funds out before you reach the age of 59.5, and you’ll receive a 10 percent penalty on top of any income tax liabilities. But there are exceptions. You might be able to make withdrawals without incurring a penalty if you suffer a disability or need to avoid eviction, for example. Some 401(k) plans also allow their members to borrow against the contents of the plan. That can be a better idea than it sounds. It’s worth know if you can do it.
You can also expect to have to begin taking distributions from the age of 72.
The time when you begin taking money out of your retirement fund might seem distant. You might be a long way from retiring, and know that cracking open your pension early is a bad idea. But you should still know whether you’re able to take the funds, what sort of penalties you’ll have to pay, and whether you can use your 401(k) for a loan.
How Much Does it Cost?
Finally, retirement funds, including 401(k) plans, cost money. Fund managers charge an expense ratio which covers their administration and other expenses. That ratio will be a percentage of the amount held in the fund.
The ratio will vary from fund to fund. Some funds are much more expensive than others so even high-performing funds can be less profitable if fees take a large chunk out of the profits.
There’s little that employees can do about the cost of their 401(k) plans. It will be up to the company to find a fund that balances performance with expense. But knowing the cost can help to calculate whether it’s worth putting your money in the 401(k) fund or in a cheaper and higher-performing alternative saving fund.
Contributing to Your 401(k) Plan
So your company is offering a 401(k) plan. You know the length of the vesting period and you’ve discovered that the company will match everything you contribute on a generous 50 percent basis. You’re ready to start putting money aside for your future.
How much do you save?
That feels like a difficult question. On the one hand, the more money you can put away the better your retirement will be. You’ll also be able to lower your taxes and the matching contributions will increase your income.
On the other hand, you won’t be able to touch those funds before you turn 59.5, and that might feel a long way away. In the meantime, you’ve got a mortgage to pay, student loans to pay off, and it might be nice to have a vacation one day. Money in your 401(k) is money that you can’t use now.
As you weigh up the amount you want to contribute to your 401(k), there are a few things you need to consider.
You can’t save as much as you want. If your mortgage is paid, the student loans paid off, the children self-sufficient, and your rental income more than enough to live on, you might want put your entire salary into your 401(k). Your income, after all, would then become effectively tax-free until you retire. If you use a traditional 401(k), you’d pay income tax during distribution, but you’d pay nothing until then.
The government is wise to that plan. The limits it places on contributions to a 401(k) plan change from year to year; they rise with inflation. In 2021, the maximum contribution is $19,500, or $26,000 for people aged over 50. Employers can only match those contributions so the total limit that an employee can put in their 401(k) plan each year is $58,000 or $64,500 for workers aged over 50.
Unless you’re a very high earner, it’s unlikely that you’re going to reach those limits. So you’re going to be faced with a much tougher question about the amount that you should save for your retirement. It’s likely to be less than $26,000.
The matching contributions will help. Failure to take full advantage of an employer’s matching contributions is like telling your boss that they don’t have to pay you so much. You’ll want to take everything they offer.
In practice, few employers will promise to add up to $26,000 to an employee’s salary. More likely, you’ll be making do with an amount that will be little better than a bonus. You might get 5 percent of your contribution or 10 percent of half your contribution. Or much less.
Regardless of the amount, a good guide to determining how much to put in your 401(k) is to take everything you can. Not contributing everything that will give you the maximum matching contribution is leaving money on the table. Ask the HR department how much you need to contribute to gain all the company’s matching funds. Use that amount as your baseline.
One important factor that will affect the amount you should be packing into your 401(k) is your age. When you’re in your twenties and beavering away at your first job, retirement will look a long way away. Your pay will also be low and you’ll have little spare cash to put aside for the next forty years.
You should still make the effort.
When you’re in your twenties, you should be trying to put at least 7 percent of your income into your 401(k). So if you’re earning $30,000 a year, that would mean saving just $175 of your income every month—and remember that those savings will lower your taxes. You can either get into the habit of putting money aside for the future, or you can give more money to the government.
As you move into your thirties and forties, you can increase that portion of your income to 8 percent. That might still feel challenging. You’re in the middle of your career, retirement still feels a long way away, and you now have a mortgage to pay, and children to pay for. If you’ve paid off your student loans, you’ll now have to start saving for your children’s future college fees.
But again, it’s still vital to continue filling your 401(k). For someone earning between $60,000 and $100,000 a year, that will mean saving between $400 and $667 a month. It might feel like a sizeable chunk of income but it’s vital to keep putting those funds away to ensure a comfortable retirement.
Your 401(k) in Your Fifties
As you move into your fifties, you’ll want to start increasing your payments. The tax authorities increase the limits, giving you even more incentives to fill your 401(k), and you should be earning more at this stage too. This is your big chance to make catch-up payments and make up for not saving enough when you were younger.
If you’re lucky, you’ll have little to save for but retirement at this age. The mortgage might be paid, the kids could be out of the house, and you should be looking forward to enjoying a retirement. It’s still more than a decade away, so you do have time to prepare for it. That’s time you need to use now.
Your sixties are your last chance to fill your 401(k). You won’t make much compound interest before you decide to stop working but you will be able to increase your payouts if you save money now. You should be aiming for about 11 percent in these years.
Some people, of course, continue working past their pension age, and not always because they don’t have enough money to retire. Some people just enjoy working. They might put in fewer hours or work part-time but that work gives them something to do. The income supplements their pensions, and it also lets them continue to save for the day they stop entirely. People who work in their seventies tend to continue to invest 12 percent of their income to their 401(k). Even if they won’t get to enjoy the payouts from those 401(k)s for long, the funds are inheritable. Continuing to put money into their 401(k)s allows them to reduce their tax liability while increasing the value of their estate.
How to Set Your 401(k) Contribution Targets
In general, over a working life, people tend to put an average of between 8 and 9 percent of their income into their 401(k)s. They aim to save enough to ensure that their total retirement income, including social security and any other sources of revenue, amounts to about 80 percent of pre-retirement income.
If your last salary is $80,000, for example, you’ll want to retire and be able to enjoy an income of about $60,000 altogether. That’s your goal. So how much would you have to save to generate that income?
It’s possible to come up with a quick back-of-the-envelope calculation. In general, experts estimate that someone who retires at the age of 60 should have about 15 times their annual after-tax retirement expenses. If you’re hoping to live on $60,000 a year, you’ll need to have saved $900,000.
Few people, though, retire at 60. But you’re not much better off if you retire at 65. You’d then need 13 times your annual after-tax expenses. So that’s $780,000. To find out how much you’d need to save each month to reach that goal, you can use a savings calculator.
If you’re 45 and you’ve already saved $100,000, for example, you’d need to put aside about $1,270 each month at an annual yield of 5 percent. If you’ve only saved $50,000, you’d need to save about $1,600 a month.
But it’s a little easier than that. You’ll also have income from Social Security.
Calculating Your Social Security Benefits
The Department of Social Security provides its own calculator. Enter your date of birth and your current earnings, and the department will tell how much Social Security you’ll receive in retirement. Someone born in 1975, for example, and earning $80,000, can expect to receive $2,539 each month in today’s money if they retire at the age of 67.
That makes the savings planning a lot easier. Now instead of trying to save enough to generate $5,000 a month, you only need to save enough to generate about half that amount, or about $390,000. If you’re 45 and have already saved $50,000, that’s only a little more than $500 per month.
Making these kinds of calculations isn’t difficult. It’s also essential, and the sooner you do it the better. It’s much easier to start saving a little in your 401(k) every month as early as possible than try to catch up just before your retirement.
We also have put together an annuity calculator if that helps!
What’s In Your 401k Plan?
A 401(k) fund is a basket that holds two kinds of assets: fixed income assets; and equity funds.
Fixed Income Assets in a 401(k)
Assets that deliver a fixed income include bonds and certificates of deposits, or CDs. They’re loans. The 401(k)’s fund manager uses the investors’ funds to lend money to a company or a government at a fixed rate of interest and for a fixed period of time.
The advantage of bonds is that they’re reliable. Governments rarely fail to pay their debts. Companies sometimes go bust but the fund manager will choose large, reliable firms that are likely to remain liquid. Certificates of Deposit come with guarantees from the FDIC that cover them for up to $250,000. They’re more like savings accounts. While companies and government issue bonds, CDs usually come from banks or credit unions.
It’s as though the 401(k) fund manager had taken some of the money and simply put it in a savings account.
There are never any guarantees when investing. A government can always default. A company can always go bust. But something has to go very wrong for bonds and CDs to lose their value. Fixed income assets in a 401(k) give the fund a stable base.
They’re also predictable. While the stock exchange can rise and fall, fixed income assets will continue paying at their interest until they’ve matured.
The disadvantage is that they also have relatively little growth. At a time when interest rates are low, those investments might make little more than the rate of inflation. The fixed income assets invested in in your 401(k) are unlikely to lose money but they’re also unlikely to make much money.
Equity Funds in a 401(k)
While the fixed income assets give a 401(k) stability, equity funds give it growth. These are usually made up of corporate shares. The fund manager will keep an eye on the stock market, and pick companies or groups of companies that they think will continue to grow. If the economy booms, the fund benefits and its value grows. But similarly, if the economy goes through a recession then the value of the equity fund assets will fall, bringing down the value of the 401(k) as a whole.
Equity funds can be high growth but they are riskier and more volatile. A 401(k) is a long-term investment though, and over time, economies usually grow. While your 401(k) may undergo periods of decline during your working life, and while you might start withdrawing from it below its peak, you should find that it grows significantly over time. The combination of fixed-income assets and equity funds should deliver a suitable balance of stability and growth.
Picking Your 401(k) Investments
You can choose to put money into a 401(k), and you can decide how much you want to invest in a 401(k), but you can’t usually decide how the fund uses that money. That decision will be left to the fund manager. The employer will select a 401(k) by looking at the results and the fund’s expenses, but will then leave the money management itself to the fund provider. They’ll talk to an agent at a company like Fidelity Investments, Bank of America, Charles Schwab or one of the other major providers, and make their choice. Having made that choice, though, the company and its employees are unlikely to do more than check how quickly the fund is growing.
They’ll have no idea where the fund has put the money. They won’t know that they own a small amount of Amazon shares, for example, or that they have lent money to the federal government.
And that’s a good thing. Investing reliably is difficult and is usually best left to professionals. They know how to track the markets. They know when to buy and sell, and they’ll do it better than their clients.
IRAs, or Independent Retirement Accounts, might give you the flexibility that 401(k)s lack. You’ll have the freedom to choose the company and maybe even the fund in which you place your money. But even then, you’re still likely to be comparing growth rates and fees rather than assessing the individual collection of stocks and bonds that the fund invests in. When you invest for your retirement, you pay a professional money manager to make sure that your money grows at least in line with the market. You want to be sure that the amount you need for your retirement is there when you’re ready to stop working.
Track Your 401(k)
But while you can’t adjust the contents of your 401(k), you should be tracking its growth. You should know how much money you have in your 401(k) and how quickly it’s growing. If you can see that your 401(k) is growing more slowly than you’d like, you can get it back on track by adding more money or by reducing your contributions and investing somewhere else.
That might happen. Over your working life, the markets will fall. There will be periods of recession. No market ever grows continuously. You should be taking the long view, and focusing on the overall percentage in growth, but if you start to see that you’re drifting away from your retirement target, you can make adjustments. You can only do that, though, if you know how much your 401(k) is worth.
Ideally, your 401(k) fund should send you a regular statement. You’ll either receive it in your email or you’ll get a paper statement in your physical mailbox. It looks like the kind of bureaucratic paperwork that you glance at then toss away. Make sure that you examine it carefully and keep it. It will help you to see how quickly your retirement money is growing.
If you’re not receiving your statement, you should be able to log into the website of your fund provider. That will show you how much you’ve contributed each month, how much it’s grown each year, and how much you’ve paid in fees. If you don’t have access to the website, ask your HR department how you can track your 401(k) fund.
The Present and Future Value of Your 401(k) and Why You Need to Know Them
What that statement will tell you is the amount that you’ve already saved. It will also give you an idea of the speed with which your savings are growing. What it won’t do is tell you whether you have the amount you need to be able to retire at the level you want.
Retirement planning often talks about the “present value” of a retirement fund. The present value is the amount of money in your account today. That money will grow. As you—and your employer—add more money to it. And as the interest compounds, the value of your fund will increase.
The amount that your fund will be worth when you retire is the “future value” of your fund.
To calculate the future value of your 401(k) when you retire, you’ll need to know:
- When you plan to retire;
- How many payments you intend to make before your retirement;
- And the rate of return you can expect to earn before you retire;
Some of that information you’ll have—or at least you can make a good guess at. While you might not be sure exactly when you want to stop working, you probably expect to do it around the age of 65. That will tell you how many more years you expect to work, and how many monthly payments you can expect to make before then.
The Value of a Future Calculator
The interest rate is a little more complex. There’s no guarantee that rates will continue to grow as they did in previous years, but you can use previous rates as a guide. In general, you can expect your 401(k) to grow at a rate of between 5 percent and 8 percent each year.
Plug those figures into a future value calculator and you’ll be able to see exactly how much you can expect your 401(k) to be worth at any point in the future.
The big question is whether that amount will be enough. That’s much harder to know. Like insurance agents, pension planners will often try to estimate a retiree’s life expectancy. The more years you’ll enjoy after retirement, the more money you’ll need to have saved before retirement.
Average life expectance for men in the US is about 76. For women it’s about 81. If you retire at 65, you can expect to enjoy your retirement for between 11 and 16 years. But these are average figures. Many people live longer than those averages—and you’ll hope to be one of them. You’ll also want to play it safe and aim to outlive your retirement payments.
You can try to come up with a rough calculation. If you expect to live 20 years beyond retirement, you could look at your current annual expenses, trim away any fat, and multiply that amount by 20. If the future value of your 401(k) at retirement is lower than that amount, you’ll need to make bigger contributions.
It is very hard though to estimate how long you’re going to live after retirement. Aiming for post-retirement income that’s about 20 percent lower than your current earnings is much easier.
Rolling Over Your 401(k)
A 401(k) plan is tied to an employer. The benefit of that arrangement is that it allows you to receive matching contributions. The downside is that few people stay with the same employer throughout their working life. There is a very good chance that at some point, you’ll want to change companies. So what happens to your 401(k)?
If the fund contains less than $1,000, your old employer will probably just send you a check. If you’re not yet aged 59.5, that check will generate taxes and a 10 percent early withdrawal penalty. You won’t see much of those few hundred dollars.
For an amount between $1,000 and $5,000, your old employer will have a choice. They can either leave your money in the plan or they can push it out. If they choose to push it out, they have to send you a notification letter to which you must reply within 30 days. If you don’t respond, they must put the funds in an IRA for you.
For amounts of more than $5,000, the choice is likely to be yours. You can choose to leave the money in your old employer’s 401(k), or roll it over to your new employer’s 401(k).
You Don’t Have to Rollover Today
This is not a decision you need to make immediately. You don’t have to tell your old employer what you want them to do with your money on the day you hand in your resignation or at the leaving party.
The time to decide is when you know the difference between your old employer’s 401(k) and your new employer’s 401(k). You’ll need to talk with the personnel department at your new employer and ask them about the performance of their 401(k). Make sure that you know the size of their returns and the amount of expenses that the fund charges. Compare those figures to the numbers that your old employer provides.
If you can see that the 401(k) at your old employer is performing better than the 401(k) at your new employer, then you should probably leave the money there. Just make sure that you don’t forget about it. As you build your career and move from company to company, there is a danger that you won’t remember all your old 401(k)s. Your money will remain growing in the fund of a place you worked at a couple of decades ago, but you’ll forget to take the withdrawals.
Every time you choose to leave a 401(k) in place, make a note. Keep track of the speed with which it’s growing. Make sure that you include that money, and its growth rate, as you calculate whether your retirement plans are on track.
Moving Your 401(k) to Your New Employer With a Direct Rollover
Forgetting a 401(k) isn’t the only risk that you face when leaving your funds with your old employer. If you no longer work for the company that holds your 401(k), you can’t use those funds as a basis for a loan. While that’s not something you’re likely to do anyway, it is a right that you might want to keep.
If you can see that your new employer’s 401(k) is performing better than your old employer’s fund, then you’ll have another reason to move your funds over. You’ll need to perform a direct rollover.
That’s less complicated than it sounds. A direct rollover simply moves your funds from one retirement account to another. There are no withdrawal penalties and no tax events.
First, you’ll need to talk to the HR department of your new employer. You’ll need to ask them where your old 401(k) should send your funds. They’ll give you an account address with your name as a beneficiary. Send that address to your old employer’s HR department and ask them to close your 401(k) account. (You can do this even if you’ve left the company on bad terms. They’ll still have to transfer the fund on your request.)
You might have to a pay fee to the investment firm that manages your funds but it won’t be much. Ideally, the money will then pass as a direct transfer between the two trustees. If your old 401(k) fund insists on giving you a check, that check will be written to your new 401(k) fund and not to you personally.
Moving Your 401(k) to Your New Employer With a 60-Day Rollover
An alternative to the direct rollover is a 60-day rollover. The old 401(k) fund writes a check directly to the account owner. The account owner has 60 days to deposit those funds into their new 401(k). If they fail to make that deposit within 60 days, the IRS regards the payment as a distribution. The account holder has to pay income tax and, if they’re below the age of 59.5, they also have to pay a withdrawal penalty.
In addition, the amount will be subject to a 20 percent tax withholding. The IRS returns that 20 percent when the account holder files their taxes that year. But the new 401(k) must contain 100 percent of the funds from the old 401(k), including the amount that the IRS withheld.
So if you were moving $100,000 from an old 401(k) to a new 401(k), using a 60-day rollover, you would receive a check for $80,000. But you would need to deposit the full $100,000 into the new 401(k) to avoid the risk of an additional tax penalty.
In general, a direct rollover is preferable, especially if you’re leaving one job without moving to another. It might be tempting to break all ties with your old company, and take a check from your old 401(k) so that you’ll never have to deal with them again. But you’ll only receive 80 percent of your funds, and if you don’t deposit all of it within two months, you might find yourself with a big tax bill. That makes not finding a new job quickly very expensive.
Borrowing Funds from Your 401(k)
One of the benefits that can come with a 401(k) is the ability to borrow from the fund.
That doesn’t sound like much of an advantage. Financial experts will usually advise against borrowing from a pension pot. They’ll argue that you’ve set that money aside for the future and you shouldn’t touch it until you retire. The risk is that having borrowed from your 401(k), you’ll neglect to pay it back. Or you’ll lose the benefits of compound interest that not touching your 401(k) can bring.
If you want to borrow money, there are plenty of other places that you can turn to, without breaking into your retirement fund.
But borrowing from your 401(k) can sometimes be a smart move that delivers some valuable benefits.
It doesn’t affect your credit rating. Because you’re borrowing your own funds, the only lender at risk is yourself. If you have a spotty credit rating or don’t want to affect your score, borrowing from your 401(k) can provide a solution.
As long as you meet the repayment rules and don’t borrow more than half the amount in the fund or more than $100,000 (whichever is less), you can borrow that money on a tax-free basis.
Lend Yourself Interest-Free 401(k) Funds
It’s also relatively easy. Because you’re the lender as well as the borrower, you don’t have to file an application or make your case to some banker. The process at most fund management firms is now largely automatic. You can process your loan online and receive the funds from your 401(k) within days.
But the biggest benefit is that a loan from your 401(k) is mostly interest-free. Any interest you pay will go back to your own fund.
That doesn’t mean that there are no costs in borrowing against your 401(k). The fund will charge you a processing fee, of course. The money that you borrow won’t be generating interest in your fund. You can expect your employer to deduct the repayments directly from your paycheck, after taxes.
More importantly, while you’re repaying your loan, you might not be able to make additional payments to your 401(k). That could cost you a year of contributions, including matching contributions. If your 401(k) fund imposes that restriction, you’ll need to calculate the cost of missing those payments against the amount of interest you would pay for a commercial loan.
And if you leave your job before you’ve repaid the loan, you’ll be at risk of the IRS considering the loan as a distribution. You’ll have to pay tax on the funds and you may also have to pay a withdrawal penalty unless you put the money back in a short amount of time. That deadline used to be either 60 or 90 days after leaving your job. Under the Coronavirus Aid Relief and Economic Security (CARES) Act, you now have up to a year but that might change as the pandemic fades. If that happens, the maximum amount you can borrow is likely to fall back from $100,000 to $50,000.
Borrowing from Your 401(k) to Buy a Home
In general, borrowing from a 401(k) happens when you really need the money. The loan should be short-term, and certainly less than a year, and you should know that you’ll be able to pay it back from your salary.
401(k) loans also tend to happen in hard times, which is also when the stock market is falling. That limits the damage to the growth of your 401(k). It might even mean that you’re able to put those funds to better use than keeping them in a declining investment fund.
The other time that people borrow from their 401(k) is to purchase a home. The rules for these loans are different. You’ll have more time to pay them back. For a second home or an investment property, the repayment period won’t be more than five years. For a primary residence, you’ll need to ask the fund’s administrator. They’ll have some flexibility.
But borrowing against your 401(k) to purchase a home is rarely a good idea. The long repayment terms mean that your retirement fund can suffer a big hole. The interest payments aren’t tax deductible in the same way as most mortgage interest expenses. The usual limit of $50,000 is unlikely to be enough to make a serious dent in the amount you need to buy a home, and the accumulation in a 401(k) doesn’t match the time people buy a home. The average age of a first-time home buyer is 34. The median 401(k) balance between the ages of 30 and 39 is just $16,500.
While you can use a 401(k) to help fund the purchase of a home, you’ll usually better off applying for a mortgage.
The 401(k) is an important tool for building a retirement fund. The passage of law that created it might not have intended to create a new way to plan for a pension but that’s how it has developed: as a retirement fund for employees with a host of benefits.
Because the 401(k) is tied to a workplace, it can receive matching payments from an employer that can significantly boost an income. It’s tax-beneficial, allowing taxpayers to move taxable income they don’t need now to a time when they’ll pay a lower tax rate—and need the money more.
Some 401(k)s—though not all—also allow for borrowing, giving investors a useful way to access short-term funds.
To make the most of those matching payments and tax benefits, you should put as much you’re your 401(k)s as possible. You should pay attention to vesting times so that you know how much you’ll lose if you leave your job. And you should know where your 401(k)s are as you move through your career, and how much they’re worth.
Track your 401(k), and you should find that your retirement remains on track.