Over the past several decades, as old-fashioned defined-benefit pensions have been fading away, employees have had to learn a new skill: managing their company-sponsored retirement plans. If you are covered by one of these 401(k) plans—named for a paragraph in the federal tax code—it’s important to understand how to make it work best for you.
In simple terms, a 401(k) is a tax-sheltered investment account to which an employee makes contributions, often matched by the employer. Over time, the account should grow as the securities in it, usually mutual funds, gain value and pay dividends. On retirement, the account owner can begin to make withdrawals without penalty and possibly at a beneficial tax rate.
But unlike traditional pensions, which put the investment risk on the company (or its professional money managers), a 401(k) puts that risk on the employee. In simple terms: your account’s value can fluctuate according to the ups and downs of the financial markets s depending on the investments you choose.
That’s a key point: as the account’s owner, you have choices. Let’s start with the most basic: should you participate in your company’s plan?
The simple answer is “yes.” Most people will need more income in retirement than Social Security will provide. A 401(k) is an excellent way to ensure you’ll have that income, and, if your company kicks in too, that’s “free money.” But in most cases, it doesn’t come automatically. You’ll need to sign up to participate. Your employer’s Human Resources department will tell you when and how to do this. When you enroll, you can decide how much of your salary you want to put into your account. That can be any amount up to $19,500 a year. You can change that contribution amount, by the way.
Your employer will make it easy to contribute by deducting the amount you choose from your paycheck. Whatever amount you choose; it won’t be taxed. Not right away, anyhow. Income tax won’t be due until you start to withdraw from your 401(k) and, most likely, you’ll be in a lower tax bracket.
For many workers, it gets even better. About half of the companies that provide 401(k) plans will put their own money into your account. Often that’s a match of 50 cents from the employer for every dollar an employee invests. Sometimes it’s more, even dollar for dollar.
Some 401(k) plans are simple: the company offers just one type of investment, which might be a mutual fund or a particular portfolio of investments. But more typically, you’ll have some choices. Just as with any other long-term investment decision, you’ll need to weigh your tolerance for risk against your wish for potentially bigger gains. When choosing among the options your company’s 401(k) offers, it’s an excellent idea to get advice from qualified investment experts.
This isn’t the place to get into the pros and cons of aggressive growth funds versus conservative funds, managed versus index funds, and the like. But you will almost certainly face choices among those and other investment options your company offers.
One more point about how much you can put in: If you are an older worker and haven’t put as much into your retirement account as you think you’ll need, a special “catch-up” provision may help you. If you’re 50 or older, you can add another $6,500 a year to the normal contribution limit.
But now come some complications. Because a 401(k) is tied to your employment, you may well need to make some decisions if you lose your job or change jobs. It’s possible, if you’re happy with your investments, to stick with the previous employer’s plan. But if your balance is less than $5,000, you may be required to cash out. It’s perfectly legal, by the way, to have more than one 401(k) account.
Whether it’s your choice or the former employer’s, when you withdraw money from that old 401(k) it’s important to promptly roll it over into another “qualified” plan. Otherwise, you’ll be on the hook for significant income taxes, and maybe penalties, too. A “qualified” plan may be your new employer’s 401(k) or your own Individual Retirement Account (IRA.) When you do this, by the way, let your company’s HR department or the company that manages your IRA arrange for a direct rollover. Taking a check from the old 401(k) will subject you to taxes and penalties.
One final issue about 401(k) plans is important to understand: whether (and how) to borrow or withdraw from your account before you’re eligible to retire. That’s defined as age 59½ unless your employer lets you (or forces you to) retire earlier. You can also withdraw money from your account, without penalty, if you become disabled. Your heirs can do so if you die. Some specific “hardship” exceptions are also available. This year, the CARES act added a special coronavirus hardship provision.
As an alternative to a withdrawal, your 401(k) may allow you to borrow up to 50 percent of your account’s value or $50,000. Whether that’s permitted is up to the employer that set up the plan. Loans usually have to be repaid within five years, unless used to buy a home. There’s a real advantage to this if you need cash quickly: interest rates are usually better than you can get from a bank, and when you pay back the money, you’re paying yourself!
Beware, though: if you don’t manage to repay the loan on time, the unpaid amount will be considered a withdrawal and subject to taxes and penalties.
Bottom line: The many advantages of a 401(k)-plan mean participating is a good deal for most employees. But you’ll still have to make decisions about how much to save, which investment options to choose, and how to manage rollovers, loans and withdrawals. Even within a single company’s plan, one size does not fit all.
To help you navigate those choices, and make sure your 401(k) fits your overall investment and retirement strategy, we recommend consulting with Old North State Trust’s retirement experts.
They can help you make the best of the possibilities your employer’s plan offers you.
Old North State Trust, LLC (ONST) periodically produces publications as a service to clients and friends. The information contained in these publications is intended to provide general information about issues related to trust, investment and estate related topics. Readers should be aware that the facts may vary depending upon individual circumstances. The information contained in these publications is intended solely for informational purposes, is proprietary to ONST and is not guaranteed to be accurate, complete or timely.