The 401(k) plan has been a long-time cornerstone in the retirement investment portfolio for Americans. At its foundation, it’s an employer sponsored savings plan that allows investors to siphon off a portion of their paycheck, either on a pre-tax or after-tax basis, into a tax-deferred investment account. While this is the most basic construct of a 401(k), many employers offer an additional matching component based on employee contributions.
Seems like a pretty good deal, right? Unfortunately, many workers do not take advantage of this retirement vehicle, and according to the U.S. Census Bureau, only about one-third of Americans are saving to a 401(k) plan or similar tax-deferred retirement plans. This crucial misstep leads us into our list of Do’s and Don’ts with your 401(k) plan.
Even in small amounts, participation in your 401(k) plan is worthwhile for multiple reasons.
- Companies with 401(k) retirement plans can often access institutional funds and pricing that the everyday investor cannot, resulting in lower fees in your portfolio.
- Similar to an IRA, 401(k)’s also offer tax-deferred growth on your investments, but allow you to contribute up to $18,000 ($24,000 if over age 50) per year versus $5,500 ($6,500 if over age 50) in an IRA.
- If your company has a matching component in the plan, take advantage of it because it’s free money!
Rolling Over Plans to Your Current Employer
Believe it or not, it costs money to administer and run a 401(k) plan. Recordkeeping and administrative fees can create a drag on your portfolio’s long-term performance. If you choose to leave an old 401(k) account with your former employer, you’re essentially paying double the fees. When you leave an employer, it’s important to compare the costs and investment options of your new 401(k) plan and an IRA to determine the best vehicle to roll it over into.
Know How Your Contributions Are Being Taxed
Most 401(k) plans will typically offer the option to make either Pre-Tax (Traditional) or After-Tax (Roth) contributions. Knowing the differences in these types of contributions is very important when strategizing for your future.
After-Tax / Roth Contributions: These contributions are deposited into your 401(k) after-tax, meaning Federal & State taxes have already been deducted. The money grows tax free, and when you elect to take withdrawals after age 59 ½, those amounts are tax free as well. This strategy is recommended for younger investors or investors in a low tax bracket, with the expectation that they will be in a higher tax bracket by the time they reach retirement age. The tradeoff is to pay less taxes now to avoid taxes down the road.
Pre-Tax / Traditional Contributions: Pre-tax contributions are deposited directly into your 401(k) account, void of any Federal and State taxes. The money grows tax free, but withdrawals are taxed as ordinary income after age 59 ½. Typically, this strategy is beneficial for higher income earners, who can deduct these contributions on their tax return and who anticipate being in a lower tax bracket by retirement age.
Review and Rebalance Your Portfolio
Continue to review your 401(k) plan at least on an annual basis to ensure your investment objectives are appropriate and that you’re up to date on the investment options. Many investors choose the default investment vehicle and don’t take advantage of the other funds being offered. 401(k) platforms also provide useful online tools, such as automatic quarterly rebalancing, which allows your portfolio to stay on target with your risk tolerance.
401(k) plans are an extremely important aspect of your retirement plan, and it’s in your best interest to use these vehicles to their full extent. Review your plan today and get saving!
Sean Knoerzer is a Senior Planner at BDF where he enjoys digging deep into the details of a client’s financial plan. He sits on the firm’s Financial Planning Committee, which is responsible for educating the BDF team on financial planning topics and improving the team’s planning process. He earned a Bachelor of Science in Agriculture and Consumer Economics with a concentration in Financial Planning at the University of Illinois. Sean is a CERTIFIED FINANCIAL PLANNER™ professional.