401(k) plans are hailed by many financial experts as one of the easiest and most convenient ways to save for retirement. However, according to data from the US Census Bureau, although an estimated 79 percent of American workers have access to a 401(k) plan through their employer, only 41 percent of those choose to take advantage of this retirement savings option.
Given the many benefits they can offer, why is 401(k) uptake so low? One possible reason could be the fact that many people, even those who do participate in a 401(k), find the rules and details of this type of plan confusing. When you’re not sure what the advantages of a 401(k) really are, or when and how you’ll get back the money you put in, it’s understandable that you might feel hesitant about funding such a plan.
If you share this confusion, and have avoided pursuing a 401(k) opportunity for that reason, read on for answers to some of the most commonly asked questions about 401(k)s.
What exactly is a 401(k)?
Simply put, a 401(k) is an employer-sponsored retirement plan that is funded, at least in part, by contributions deducted directly from your earnings. Your employer invests this money on your behalf in a retirement fund, where it will grow on a tax-deferred basis until you withdraw from it.
Why would I choose to participate in my employer’s 401(k) plan?
There are a number of reasons why investing in a 401(k) through your employer makes good financial sense. The first is the opportunity for a tax break. The money that you contribute to a 401(k) comes directly off your salary before taxes, which in turn lowers your taxable income and results in a smaller tax bill.
Another important reason to participate is to take advantage of employer contributions. As part of their 401(k) plans, many employers will offer to match whatever money you put in up to a certain percentage. This essentially amounts to free money from your employer, and is one of the biggest benefits that a 401(k) can offer over other retirement savings options. For example, it is fairly common for an employer to contribute or “match” 50% of what you put into the 401k up to a certain percentage of your salary-such as 3% from the employer if you contribute 6%. This is essentially a 505 return on your money, even if you leave it in cash in a money market choice! We urge all people to contribute up to the maximum match offered by the employer for this reason.
Finally, investing in your employer’s 401(k) plan can be worth it simply because it’s so convenient. Once you’ve enrolled in the plan and set your desired contribution level, that money will be set aside each month without you having to make any effort or even think about it at all.
How much money should I invest in my 401(k)?
The amount you choose to contribute to your 401(k) will depend on a number of factors, such as your anticipated expenses during retirement, your current assets and debts, and the tax advantages you can gain from different contribution levels. As a general rule of thumb, however, most experts recommend that you put a minimum of 5-10 percent of your paycheck toward your 401(k).
Finally, do be aware that 401(k)s have contribution limits attached. For 2021, employees can put up to $19,500 towards a 401(k).
How is the money in my 401(k) invested?
While your employer does make certain investment decisions on your behalf with a 401(k), it’s important to understand that you do have some choices when it comes to how your 401(k) contributions are invested. Most plans offer some combination of actively managed domestic and international stock funds, domestic bond funds, and money-market funds, as well as low-cost index funds.
Depending on your investment goals and risk tolerance, you can choose how you want your money allocated, and you can also make changes to your investments over time. If you don’t know where you want your contributions to go, the default option will typically be a money-market fund or a target-date fund. Unfortunately, most 401k plans do not offer a truly broad menu of investment choices. For example, there are often no choices in the following asset categories, which can mean lots of lost opportunities for growth and returns over time: precious metals; natural resources; emerging markets; real estate; foreign bonds; etc. It is therefore important for you to try to gain a presence in these other asset categories with non-401k funds, if possible, in order to be truly diversified in your pursuit of long-term growth for retirement.
What do I have to do if I want to join my employer’s 401(k) plan?
Some companies offer automatic 401(k) enrollment, which means that you’re automatically included in your employer’s 401(k) as soon as you start working. Other companies take an “opt-in” approach. This means that you’ll need to fill out a form and submit it to HR to set up your 401(k) and start having contributions deducted from your pay.
In either case, you can talk to someone from HR or payroll if you have questions at any time about your 401(k), or if you want to change details such as your contribution amount.
What happens to my 401(k) if I move to a new job?
Because 401(k) plans are employer-sponsored, employees are often confused about what will happen to their 401(k) if they leave their current job. The good news is that you do have several choices in this situation.
You can simply leave the money in your employer’s plan, where it will continue to be invested; you can roll the money into a 401(k) at your new employer, if they offer one; or you can roll the money into an individual retirement account (IRA). You also have the option to simply cash out your 401(k) when you leave an employer, although this is not usually recommended as it increases your tax burden significantly and wipes out future financial gains. If you “roll over” the funds in your 401k to an IRA when you leave that job, there are no tax consequences. In other words, the entire amount of the 401k being rolled over into the IRA account will not be taxed-those funds will continue to grow tax deferred in the IRA, and now, in that IRA, you will have many more investment choices available to you.