Saving for retirement is crucial for everyone. Defined benefit plans, such as a pension plan, is not something that is readily available for most people any longer. With a defined benefit pension plan a person retires and guaranteed automatic payouts during retirement years are provided typically based on a person’s salary and years of service. This is a really good benefit to have at retirement.
For many year’s pensions were a standard retirement plan that many employers provided. Some do still offer these, but they are becoming much rarer. Most employers have opted to offer 401k plans in place of these because they can be less expensive to administer. As companies continue cost cutting and fuel the philosophy of more with less, more defined benefit pension plans will likely start to disappear.
401k’s do offer the advantage of people making their own investment decisions within their plan as opposed to a pension plan where the employer or sponsor of the plan is responsible for making decisions. 401k participants are left with the investment choices available in their plan to invest for retirement.
For individuals having control over their 401k plan, this is a responsibility they must take seriously. Plans may offer good investments or bad investments with high fees or low return rates. They may also offer plan participants the option to take out loans. Employers sometimes even offer matching contributions. Being 401k’s are for retirement, it is important for plan participants to ensure the investments have the possibility of growing as much as possible and also avoid mistakes.
Here are some Do’s and Don’ts for 401k’s.
401k Do’s
Contribute
Do contribute to a 401k if your employer offers one. The key to having enough money in retirement is to save. Save early and as much as possible. If there is one piece of advice for someone just starting out in the world, it is to save for retirement whenever you can. However big or small the amount may be, put some money away.
It can be challenging in today’s world with the costs of living and job changes that occur for many people. But save whatever amount is available. Even if an employer does not offer a 401K, open a traditional IRA or Roth IRA and start putting a little bit away. With just $50 here and there it will start to add up over time.
The significant benefit of starting to save early is time. With just even a small amount saved on a regular basis, it will grow over time. The more time it has the more it can grow. It can go through the swings of the market as a long-term investment and starting early allows a person to invest more aggressively. Thus, giving retirement dollars the opportunity to work hard and grow.
Traditional 401k and Roth 401k
More employers are starting to offer the option of a traditional 401k and a Roth 401k. The difference is a traditional 401k’s are treated as before tax. The money will be taken out of a paycheck before taxes are paid. Thus, lowering a person’s tax bracket. Taxes will still need to be paid on this money, but it will be at the time it is withdrawn.
After-tax dollars fund Roth 401k’s. The advantage to this is taxes are paid at the time of contributions and withdrawal’s are free of tax at retirement.
Traditional or Roth 401k?
The decision to contribute to either a Traditional or Roth 401k is a personal decision and will depend on a number of factors. These could be your salary, current tax bracket or expected taxes at the time of retirement. If you are not sure of which one is best, seeking the help of a financial professional is always best.
Personally, if it is available, I would contribute a little to both. These cover the basis of having tax free money at retirement and the benefit of a lower current tax bracket. The issue with knowing which one is best is no one can look into the future. There is always the possibility of tax rates increasing in the future, which is likely with the deficit the country has. But we all just never know. A person could also earn much more money in the future. This will allow them to save even more with the result of being in a high tax bracket at retirement.
The decision on which one to choose can be difficult. But at the very least plan for some tax-free money at retirement.
Contribute to A Match
Starting out in the workplace it can be hard to save much money. However, if you work for an employer that offers a match to 401k contributions, make sure to at least contribute up to the maximum amount to get the employer matching contribution. For example, an employer that will match up to 6% of a person’s contributions needs to make certain they are putting at least 6% into their 401k.
Matching 401k contributions from an employer is a benefit and equals a larger pay rate or salary. Why would you want to work for less? Do not leave money on the table. Employers will get everything they can out of their employees. It is important to get everything you can out of your employer.
Do Know What Amount You are Contributing to Your 401k
It is surprising how many people do not even have an idea of how much they are contributing to their 401k. When you start a new job, you may even be signed up automatically for contributions without knowing. Many employers will do this at a predetermined rate. If they have a matching contribution, the rate they enroll a person may not even be the rate to take advantage of a full matching amount. It is always best to know what is being contributed.
Do Learn the Basics
If you are not very knowledgeable about investments, now is the time to learn. You do not have to be an expert, but at least take time to learn the basics. There is often not much help from an employer on making the investment decisions in a 401k plan. If you do need help, look for a qualified financial advisor. One that is more of a teacher about investments rather than being more concerned about getting compensated.
Do Carefully Pick the Investments in a 401k
Research the investments, their fees, and history of performance. If you get assistance from a financial professional ensure they thoroughly explain the choices they would make and why. Pick a good asset allocation with the investments provided in the 401k plan. There are free resources on the internet where you can enter for example mutual fund symbols and it will compute the results based on the asset allocation. With mutual funds, there can be a large number of investments inside them.
It is important to not for example just look at something like a growth mutual fund and assume the majority of the investments are stocks. Free resources available, such as Morningstar, have planners that will examine mutual funds giving an overall picture of an allocation. This may include sectors of investments such as technology and healthcare. It can also tell what portion of investments is invested in stocks or bonds.
Do Only Contribute Up to the Maximum Matching Contribution if Investment Choices are Not Good.
The most important thing for planning retirement is to make sure the money invested has the best chance to grow to the largest amount possible. Most 401k plans have at least a few decent investments to choose from. However, in the rare occurrence that a plan has very high fees or investments with a history of poor performance it may be better to only contribute enough to get an employer match if it is offered. Poor investment performance and fees can make a large difference at retirement on the balance of an account.
If contributions are only put into a 401k to receive the matching amount, open a separate Roth IRA at a brokerage firm and contribute up to the maximum amount. This will depend on your income qualifications.
How Does A Person Know if a 401k Offered Might Not be a Good One?
Are there only proprietary mutual funds in the plan? When looking at investments with mutual funds are the only choices available from one financial institution? Having investment choices is important. Funds and their companies differ on fees, expenses, and performance. If choices are limited, the plan may not be a good one.
A single mutual fund family could also be an issue. Are all the mutual funds available in the plan from one fund? For example, the widget stock fund, the widget bond fund, or the widget real estate fund? This would limit the choices available.
Expensive fees were already mentioned to check and it is important to look at these. If the share classes or fees are very high, it is important to limit the contributions if lower fees are available with another retirement type. Fees or expenses may not seem that big but take them over 20 or 30 years and this can eat away at investment returns.
401k Don’ts
Don’t Make the Decision to Not Contribute to a 401k.
Just like previously mentioned, it is important to contribute. Even in the rare situation with a plan that may not be perfect, contribute up to the match when it is available. Do not make the decision to not make contributions thinking retirement is a long way out or you may do it later. Try to do at least up to the match. If this is not possible, contribute to what is possible and plan on increasing the amount.
Don’t Take a Loan
Taking a loan from a 401k is not a wise decision. Most financial experts would agree with this and some would say there may only be rare circumstances when it should be done. I would caution against taking a loan from a 401k at any cost.
401k’s are intended for retirement savings. Taking a loan from one may come with a low-interest rate compared to other choices for someone needing a lender, but it puts a person’s retirement funds at risk.
Risk Retirement Funding
First, any amount taken from a 401k as a loan is money that is not in the account that can grow. This can make a significant difference in the amount of money someone may have for retirement years depending on the size of the loan taken and repayment period. Also, some plans do not allow further contributions if there is a loan. If an employer is matching contributions, these are missed.
401k Loans are a Loan
A 401k loan is exactly this. It is a loan and the money needs to be paid back into the plan. Most often the borrowed money will have to be repaid within five years. A slightly longer repayment period when the loan is used to purchase a home. 401k loans can have a much better interest rate than other loan types, but they will require repayment. The only difference is the interest is paid back to yourself and credit to the account. The loan to one’s self and paying interest back to yourself is one of the lures in taking a 401k loan.
Job Loss
Losing a job is one of the biggest risks with taking a 401k loan. With statistics showing that most people do not stay with the same employer for very long periods of time, job loss is a real risk that almost everyone should not take.
The issues with taking a 401k loan and a person’s employment ending are the real danger. This is due to the possibility a loan is not repaid and the tax consequence results. Starting in 2018 the laws changed how 401k loans are treated. Previously a person that lost employment had just 60 days in most situations to repay a 401k loan. This has now changed to the date of a person’s federal tax return. A little further with an extension.
The danger of job loss and taking a 401k loan is repayment will not be made when it is required. This will result in the loan being treated as a distribution with taxes and likely penalties applied depending on a person’s age. The distribution will be treated as ordinary income if a person is 59 ½. If younger, it will be treated as ordinary income with a 10% early withdrawal penalty. The costs will be big depending on someone’s tax bracket and with a penalty, they will be outrageous.
Do Not Use 401k Funds to Buy A House
Taking a loan from a 401k to buy a home is just not a good idea. Some people may not agree with this. But taking any type of loan from retirement assets is a risky proposition. It may be tempting and a real estate agent may even hint at this, but I would recommend not even to consider the idea. There is too much at stake to possibly lose.
Don’t Cash Out of a 401k Plan
Cashing out of a 401k plan or any retirement plan for that matter before reaching retirement is just a plain old bad idea. With 401k plans, the same taxes and penalties will apply as not repaying a loan.
Don’t Leave Money in a 401k When Leaving a Job
Do not leave money in a 401k at another company. This happens quite often. Depending on the balance it could be left where it is or rolled over to another employer. Although rolling it over to another employer’s 401k plan may be an option, it is often best to roll it to an IRA. There are typically more investment options available in a traditional IRA than a 401k plan. There is nothing wrong with doing this and it offers more options. The money may also possibly be rolled over into a Roth IRA by paying taxes. Leaving 401k money with another company opens the possibility of forgetting about it. It will be much easier to manage retirement assets in one or a few places rather them being among a number of employers.
401k Loans are Just a Bad Idea
Taking a loan from a 401k is just not a smart financial decision. Why put your retirement at risk? Taking a loan from a 401k is a gamble that shouldn’t be taken at any cost. With statistics showing that a majority of workers may change jobs many times in their career, moving from one employer to another is a real possibility. Also, as companies move to the lean mentality of more with less to increase their bottom-line layoffs are a reality for many.
Loss of employment in combination with the taxes and penalties for not paying back a 401k loan it is like playing a game of poker. The end result could be having substantially less at retirement or having to work more years to get there.
I always say there are exceptions to a lot of things in life. Taking a 401k loan should not be one of them at all costs. Try getting a loan from another source or even go to the pawn shop before risking retirement. Taking a 401k loan should be the absolute last choice.
