7 Basic Things You Should Know About Your 401k Plan

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I recently spoke with a good friend from college who had the misfortune to lose his job.

Did you have a 401(k)?” I asked him.

“I think so,” he responded. “I see money coming out of my check going somewhere.”

I continued to inquire. “Do you know how it’s invested? What about a company matching contribution?”

My friend paused a moment before answering, “No idea. I think the company does contribute something but I don’t know how it works. We had some guy come and talk to us and show us the investments. I picked one he said was good.”

“Are you going to rollover the account?”

“Why would I do that?” he answered.

It’s times like these that I utter to myself, “Wow.”

Contributing money to your 401(k) can be a smart way to save money to reach future financial goals. While contributing it’s important to understand the benefits, limits, and rules associated with your plan. Here are 7 things you should know about your 401(k).

1) Investments Grow Tax-Deferred

This means you pay no taxes on the earnings on the account until it is withdrawn. The income is not even reported to the IRS. It’s not until the money is withdrawn, usually at retirement that you owe any taxes.

2) Contribution Limits & Tax Deductions

For 2012, the maximum 401(k) contribution is $17,000. If you are over 50 you are eligible to make a “catch up” contribution of $5,000. These contributions are above-the-line tax deductions meaning they immediately reduce your taxable income. For example, an individual in a 25% tax bracket who makes a $1,000 contribution will save $250 in taxes.

3) Investing Your 401(k) Money

How you allocate your money is critical to its long-term growth. Your investment strategy should change over time. Being younger allows one to invest more aggressively and have more of their plan invested in stock funds. As an individual nears retirement, protection of principal becomes paramount. A smaller share of money would be invested in stock funds, and more to bond funds to help achieve this. Income producing assets will also help provide distributions for the remainder of one’s life. If you’d like a second opinion about how to invest and manage the funds, consider hiring a fee-only financial advisor… someone like us!

4) Withdrawal Rules

401(k) withdrawals are taxed as ordinary income. An additional 10% penalty will be assessed on the amount withdrawn if you have not reached at least 59 ½. There are few exceptions to this penalty. Talk to your 401(k) plan provider, a tax professional or financial advisor if you are considering early withdrawals.

You may take advantage of continued tax-deferred growth and delay receiving distributions until April 1 of the year following the year in which you turn 70. At this time you must begin withdrawing the Required Minimum Distribution (RMD) annually. RMD is calculated is by dividing the balance at the beginning of the year by your life expectancy in the Uniform Life Expectancy Table published by the IRS.

5) Rollover

When you leave a job, you typically have four options: leave the money in your old employer’s plan, roll into your new employer’s plan, put it into an IRA, or withdraw the balance. If your current plan has a wide selection of investment choices with low fees and there is no charge to stay in the plan, it’s fine to leave it where it is. If you have access to your new job’s 401(k) right away and it provides inexpensive investment choices, then it’s fine to roll the new balance into your new account. More often than not, neither of these are the best option. It usually makes the most sense to transfer the funds to a rollover IRA brokerage account that offers far more investment options, including but not limited to no-load, low-expense index funds. Educate yourself or talk to a financial advisor about the benefits of investing in these low-cost mutual funds. If you withdraw the money or your old plan sends you a check for the balance of the account you have just 60 days from the time you receive it or roll into an IRA to avoid penalties.

6) Employer-Matching Contributions

Who doesn’t want free money? If you don’t understand the rules and fail to take advantage of employer-matching contributions you are turning away free money. A common formula is to match 50% of employee contributions up to the first 6% of salary. Many employers will automatically enroll plan participants at a 3% savings rate if they don’t opt out or elect otherwise. Find out your employers maximum match so you don’t miss out on an extra 3% in this example.

High-earners often want to contribute as soon as they have the salary to do so. Be careful. This strategy can backfire. By electing a higher savings percentage, the employee maxes out there contribution sooner and misses out on subsequent employer matches. It’s worth noting that if your plan doesn’t offer employer-matching contributions, maxing out an IRA first at a brokerage account with far more investment choices may be an option to consider. This assumes one falls within the income limits for investing in an IRA. Any ensuing savings could then be contributed to the 401(k) plan.

7) Roth 401(k)

Ask your company if they offer a Roth 401(k). Contributions are made after-tax, grow tax-deferred and can be withdrawn tax-free at 59 ½. This can be a great option to consider if the tax deduction does not improve tax liability for the year. Work with a tax professional or financial advisor to project ahead and see what will work best for your situation.

-by Brian Duvall