“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into traditional 401(k) retirement plans grow on a tax-deferred basis, shielded from investment taxation until money is withdrawn.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:
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 The benefit here is that your earnings grow tax free and can be withdrawn tax free moving forward unless you fail to take your annual Roth 401(k) RMDs once you turn 72. 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. 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.
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:
Once vested, matched funds represent an immediate return on your investment, so it is important to take full advantage of 401(k) employer match.
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.
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.
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).
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 02/12/2020. Retirement Topics – 401k and Profit Sharing Plan Contribution Limits.
2Internal Revenue Service as of 02/12/2020. Retirement Topics – 401k and Profit Sharing Plan Contribution Limits.
3Internal Revenue Service as of 02/12/2020. Retirement Topics – 401k and Profit Sharing Plan Contribution Limits.
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.