401(k) Retirement Plans: Perhaps the Next Best Thing to a Free Lunch

“There is no such thing as a free lunch,” as the old saying goes. However, when comparing investment alternatives, some believe there’s nothing better than a company-sponsored 401(k) retirement plan—and, in our view, that may be as close as you can get. Following are a few advantages of such plans and some ideas on how you can use them to meet your retirement investment goals.

A 401(k) retirement vehicle is typically arranged by employers for their employees. Pre-tax contributions into traditional 401(k) retirement plans grow on a tax-deferred basis, shielded from investment taxation until money is withdrawn. As a further incentive to save, many employers match employee contributions to some extent. Typically, the employer’s match is based on a specific percentage of an employee’s pay, and it is often subject to a vesting period. By vesting period, this means such funds will only become part of your retirement asset base if you stay with the company for a specified amount of time.

A few more basics regarding 401(k) retirement plans:

• Contribution limits. The current limit for contributions for qualified plans is $18,500 per year in 2018. For those over age 50, the IRS allows “catch-up” contributions of an extra $6,000 per year.¹
• Company match limits. Not all employers offer matching contributions, but for those that do, there is a limit. The employer’s contributions combined with yours cannot total more than $55,000 in one year. ²
• Withdrawal ages and penalty. Since 401(k) plans intend to grow assets for retirement, a 10% penalty is normally assessed on early withdrawals before age 59.5. Once you have reached that age, you may begin taking distributions without penalty. However, you aren’t required to withdraw until age 70.5. At that point, you must begin withdrawing at least a certain amount each year called a Required Minimum Distribution (RMD).³

Traditional Versus Roth 401(k) Plans

It is important to understand the differences between two types of 401(k) retirement plans: Traditional and Roth.

In a Traditional 401(k) retirement plan, contributions are made on a pre-tax basis, meaning you don’t pay any taxes upfront. The investments then grow tax deferred. When you start taking distributions, you must then pay taxes at your income tax rate at that time. Roth 401(k) contributions are made on an after-tax basis. The benefit here is that your earnings grow tax free and can be withdrawn tax free moving forward unless you fail to take your annual Roth 401(k) RMDs once you turn 70 ½. This means when you begin taking qualified distributions (after age 59.5), you do not pay any income taxes on the withdrawals or capital gains taxes on the growth.⁴ A simple way to avoid taking annual RMDs from your Roth 401(k) is to roll the funds into a Roth Individual Retirement Account (Roth IRA). Rolling the funds into a Roth IRA will maintain the money’s tax-deferred status and ensure your withdrawals will never be taxed. We will discuss more about rolling over 401(k)s later in this article.

The Match Game

While you are responsible for putting money into your 401(k) retirement plan and managing investments, many employers provide extra incentive by offering a 401(k) match. This involves the employer offering to contribute a certain amount of money to match what you contribute. Here are some of the most common employer match methods:

• Percentage match. Here, an employer matches a worker’s contribution to a certain percentage of his or her salary, usually between 3% and 6%. That means the employer would contribute up to 3% to 6% of the employee’s salary as long as the employee contributes that much. For instance, a 6% contribution with a 6% match would essentially double your savings rate. But remember, matched funds might be subject to a vesting schedule, and thus not credited to your account until you have been with the company for a certain length of time.
• Dollar amount match. Rather than match a contribution percentage, some employers match employee contributions by specified dollar value.
• Stretch match. In a stretch match, the employer stretches the offering, for example, to perhaps 50 cents on a dollar, up to 10%. This means the employer contributes the same dollar amount, but you have to commit to a higher contribution rate to take full advantage of the match.

Once vested, matched funds represent an immediate return on your investment, so it is important to take full advantage of 401(k) employer match.

The Beauty of Automatic Deposit

It’s harder to spend money you never see. That is one way to look at automatic investments made to a 401(k) retirement plan. Once you designate the amount to be taken from your paycheck, contributions to your 401(k) plan are automatic. They help you stay disciplined and dedicated to saving for retirement.

It Is Still Your Money

At some point, you might feel the temptation to withdraw or borrow money from your 401(k) retirement plan to cover high medical costs, combat a personal crisis or manage a family emergency. However, funds in a 401(k) might face a tax penalty for early withdrawals, though some exceptions may be available depending on the situation. For traditional 401(k) retirement plans, this penalty applies over and above your ordinary income tax on the withdrawal.

If you need cash to buy your first home, you can borrow money from your 401(k) retirement plan—effectively loaning money to yourself. But you will need to pay your account back with interest. Often, you must pay back a 401(k) loan within 5 years. If you fail to pay it back, it might be considered an early withdrawal, subject to all taxes and penalties.

Rolling It Over

When you leave a job—whether due to retirement or simply to move to another company—you have several options for your 401(k) retirement plan. If you are happy with the plan, custodian and investment choices, you might be able to keep your plan where it is. If your new employer sponsors a 401(k) retirement plan, you can transfer it there, either all at once or over time. If you request that your former employer close your account and send you a check as a withdrawal, you would be required to pay any applicable taxes and penalties. Finally, you can roll your 401(k) retirement plan into an Individual Retirement Account (IRA).

401(k)s and Individual Retirement Accounts: A Comparison

There are a few potential drawbacks to a 401(k) retirement plan in comparison to an IRA. For example, employers usually limit the investment choices to a few options. Additionally, your employer must appoint the custodian for employee 401(k) assets, but you get to choose where to open your IRA. In general, though, the benefits of 401(k) retirement plans—high contribution limits, employer matches and tax-deferred investing—make them an attractive consideration for retirement savers.

IRAs remain popular among investors for good reason—they are usually easy to set up, and many have no setup or annual fees. Investment choices can be flexible. However, income limits mean that some high earners might not be able to contribute to a Roth IRA. Plus, the contribution limit for IRAs is lower than for 401(k)s.⁵

As you approach retirement, Fisher Investments can help ensure you have the right asset allocation and guidance. If you don’t know where to start, you’re not alone. Whether you’re already retired or still building your career, we can help answer some of the most pressing 401(k) retirement plan questions. Call us or visit Fisher online to learn more.

¹Internal Revenue Service as of 11/07/2017. Retirement Topics – 401k and Profit Sharing Plan Contribution Limits.

²Internal Revenue Service as of 11/07/2017. Retirement Topics – 401k and Profit Sharing Plan Contribution Limits.

³Internal Revenue Service as of 11/07/2017. 401(k) Resources Guide – Plan Participants – General Distribution Rules

⁴Internal Revenue Service as of 11/07/2017. Retirement Plans – Retirement Plans FAQs on Designated Roth Accounts.

⁵Internal Revenue Service as of 11/07/2017. Retirement Plans – Retirement Plans FAQs Regarding IRAs Contributions.