For most people who are trying to save for their retirements an employer-sponsored 401(k) can be an incredibly great deal. The premise of a 401(k) is reasonably easy to understand. You take pretax dollars out of your paycheck, invest them over a number of years and ultimately wind up with a really nice nest egg come retirement. On the downside, 401(k)s have some rules that can be difficult to understand. So the important thing is to know the dos and don’ts of a 401(k) so you’ll know how to get the most out of yours.
Do begin saving early even if you don’t earn much
One of the most powerful forces in the known universe is compound interest. If you save just a little cash and give it a lot of time to grow this will be better than saving a lot of cash but for a short period of time.
Don’t be afraid of growth
If you start early you have a fair amount of time to offset any losses. Stop worrying about things and keep that 401(k) in growth mode. This means investing in US and international stocks. These will carry more risk in the short term but over many years they will be a much better wealth creation tool. You should even consider investing in stocks if you’re in your 40s or 50s because you could easily live to 80 or 90.
Do take advantage of your employer’s match
If your employer matches your contribution to some percentage take full advantage of it. This is basically free money. Your employer puts it in your 401(k) account as a reward for saving, which is something you should be doing anyway.
Don’t treat your 401(k) as if it were a checking account
You can borrow from your 401(k) but you need to be careful because it can be very costly. You’ll not only pay a penalty for any withdrawals you make before age 59 ½ you’ll also be short of that cash when it comes time to retire or in an emergency. The bottom line is that you should exhaust every other option for borrowing money before you dip into your retirement funds.
Do contribute from your bonuses
When you get a bonus it can be very tempting to use it for a beach vacation and there is nothing wrong with using part of it for that or for a pair of special shoes. But put the rest into your 401(k) account to help feed your long-term savings.
If you’re getting close to retirement, are behind on your saving and are 50 or older remember that you’re allowed by the IRS if to contribute an additional $6000 for the tax year 2015 and that’s above the normal $18,000 limit. That makes a total of $24,000 you could invest in your 401(k). This can be a powerful catch-up tool.
Do increase your contributions when you get raises
There are a huge number of studies showing that when you make your saving automatic you don’t notice that missing money as much. Make arrangements with your HR department to adjust your 401(k) contributions each year when your salary increases. You’ll never miss the money and you’ll be glad you did this come retirement time.
Don’t ignore those taxes
The sad fact is that you don’t really have as much money in your 401(k) as you think. The reason for this is that it’s a tax-deferred account meaning that when you begin withdrawing funds the money will be taxed as ordinary income. If you don’t think this can hurt think about this. If you have $1 million in your 401(k) and withdraw the full amount you would pay the top tax rate, which as of this writing is 39.6% meaning it would cost you $396,000. Ouch!
Do learn if there’s a vesting schedule
While you may be getting a nice matching contribution from your employer do understand that it may have put strings on it through what’s called a vesting schedule. What this translates into is whatever money you contribute into your 401(k) will always be yours. However, some employers can and do reserve the right to get back its matching funds if you quit before you become vested. While federal law limits vesting schedules the terms can still be nasty. As an example of this, your employer might require you to work a minimum of three years or lose every single penny of what it matched. Check out your vesting schedule and make sure you understand its terms. This could actually help you decided when to – or not to – get a new job.
Don’t forget about your RMDs
RMDs are those required minimum distributions the government makes you take out of your 401(k) when you reach age 70 1/2 if you’re no longer working. How much you’ll be required to take out of your 401(k) involves a lot of math based on your account balances, age and marital status. This means that once you reach that 70 ½ and are required to start taking money out of your 401(k) you should consult with a tax professional or check out the RMD worksheets available on IRS.gov. This is important because if you don’t take out the required amount you can expect the government to penalize you so it will get its share regardless.
Do think long-term and diversify
The retirement giant Fidelity Investments made the astounding discovery that it’s best-performing accounts were those of people that didn’t even realize they had accounts. This is proof positive of the power of sticking with investments and not being influenced by day-to-day changes. What you need to do is diversify across asset classes including bonds and stocks and think both domestically and internationally.
Don’t be afraid to ask for assistance
When you reach that golden age where you’ve paid off your mortgage and paid for your kids’ college educations you need to think about the kind of retirement you want and the type of legacy you want to leave your heirs. And most importantly you need to think about when and how do you start moving money around to get there. These are critical questions and there’s nothing wrong with looking for help. An accredited financial advisor could help you navigate the various tax laws and figure out a long-term plan that would help keep those golden years golden. You don’t want to make an expensive mistake late in life and paying a smart person to help you could be an excellent investment.
If you’d like to know more about 401K)s, here’s a video courtesy of National Debt Relief with details.