What are 401(k) plans, and what should you know about them?
401(k) plans
A 401(k) plan allows an employee to choose between receiving compensation in cash or putting some of this cash into a company-sponsored 401(k) plan. Money that is put into the plan is not taxed until it is withdrawn from the plan. Funds contributed to the plan reduce your federal and state taxes as those contributions are subtracted from gross income when filing tax returns.
For example, if you contribute $1,000 and your federal marginal tax rate is 25% and your state tax rate is 5%, you will reduce your federal taxes by $250 and your state taxes by $50.
If you have the option of contributing to such a plan, should you do it? Generally, the answer is yes, but you need to do a little research first.
Your federal taxes
Are you likely to owe any federal taxes based on your income? The standard deduction for individuals is $14,600 in 2024. Do a quick search on “2024 income tax brackets”, determine which bracket you fall in, and deduct the $14,600 standard deduction. If you are not likely to owe federal taxes, then a 401(k) which allows you to defer taxes is not very useful for you from the perspective of saving federal taxes.
Vesting periods
What is the vesting period? A vesting period is the amount of time an employer mandates that you must work for the company before you can leave with the funds your employer has contributed as a match. The shorter the time, the better.
Note the distinction here – you never lose the funds you have contributed, but the vesting period may restrict when you can leave with funds your employer has contributed.
Company matches
Is there a company match, and how exactly is it computed? A match is when your employer contributes a certain amount to your retirement savings plan based on the amount of your own annual contribution.
Employers usually choose between two approaches: 1) match a percentage of employee contributions up to a specified dollar amount of total salary, or 2) directly match employee contributions – dollar for dollar – up to a specified dollar amount of total salary. The most common match, according to Vanguard’s 2018 How America Saves report, is 50% of every dollar an employee contributes, up to 6% of salary.
It’s important you understand how this is computed because you may wish to contribute only a portion of your salary up to the point where the employer contribution stops, and then use any additional funds you may have to invest somewhere else where you have more options to choose from.
Investment options
What are your investment options under these plans? They are likely to be mutual funds, and these options vary greatly from one plan to another in both numbers of choices and in quality of those choices. If you don’t know how to evaluate the investment options available to you, consider consulting a competent professional How to Choose and Work With a Financial Adviser to analyze them for you and to make objective recommendations.
The average 401(k) plan includes 8-12 investment options, most commonly mutual funds.
Plan fees
What are the plan fees – administrator fees, investment fees, commissions, loads and sales charges, 12b-1 fees, etc.? You can find some of this information in your 401(k) plan’s summary description, and you want to know what they are before you sign up. You can also ask for a prospectus for any funds you are considering or all of the funds the plan offers.
You also want to know how these fees are paid – are they deducted from investment returns, paid by the employer, or deducted from the plan’s assets? According to 401(k) analytics firm BrightScope, fees range from a low of 0.20% to 5.0%.
Your future work plans
What if you expect to work for only a short time, or have no idea how long you might work, with your new employer, should you still consider a 401(k) plan provided the vesting period starts immediately?
Short answer: yes, because when you leave you have the option of rolling over your contributions from a 401(k) to an IRA by doing a trustee-to-trustee transfer that does not result in any taxes being due. You don’t “lose” your money or have it taxed if you meet the IRS guidelines when moving funds.
Before you decide to do a rollover, compare the investment options and fees from your existing plan with your new employer’s plan; it may or may not make sense to do a rollover.
Borrowing options
Can you borrow (borrow, not withdraw) some of your own money from your 401(k)? Yes, if your plan allows it, but don’t do it because the loss in future retirement income is likely to be substantial, and you may never repay it even with the best of intentions which will result in significant taxes and penalties being assessed by the IRS.
If you decide to borrow anyway, ask yourself if you are using the loan to live beyond your means, and make sure you have a realistic plan to avoid default.
Plan flexibility
Can you move a portion of your 401(k) balance to an IRA while you’re still working for your employer? Yes, provided your employer supports in-service distributions. If your employer offers funds that do not meet your investment objectives you might want to consider an in-service distribution. Before you do however, make sure you discuss it with a tax advisor or financial planner as the rules can be tricky.
If your employer allows in-plan conversions, you may be able to convert assets in your 401(k) to a Roth 401(k). See How to Choose Between Traditional 401(k)s and Roth 401(k)s. Once again, consult a tax advisor before proceeding.
Is participation in a 401(k) plan enough to assure you a comfortable retirement?
If you do participate in a 401(k) plan, should you rely on that plus hoped-for future Social Security benefits as your only financial assets to assure a comfortable retirement? Maybe, if you have well above average earnings over a long period of time contributing to the 401(k), and you were born before 1960. Beginning in 1960 the age for Social Security full benefits begins rising from 65 to 67.
If you do not expect to meet both of these criteria, contributing to 401(k)s is still a good idea, but it is not the whole answer to achieving a comfortable retirement.