The 401(k) offers a great opportunity for many Americans to try their hand at investing while also benefiting from the added security provided by employer contributions and special tax exemptions. However, those with less experience in investment markets and tax policies may find it difficult to navigate the finer details of their 401(k) plan. Here are 4 helpful tips for boosting the value of your 401(k) and making the most of your retirement savings.
First, it has to be established exactly what a 401(k) is and why it is an essential investment vehicle for making the most of your retirement savings and securing your financial future. The 401(k) is a retirement plan offered by many employers that derives its name from the section of the Internal Revenue code that defines its rules. Employees are able to make contributions to their 401(k) in the form of payroll deductions; their employers then pledge to match a portion of those contributions.
The structure of your employer’s contributions will differ depending on the terms of your particular plan. Some companies offer contributions as a flat percentage of those made by their employees, whereas others calculate contributions based on a profit-sharing model, in which a portion of all pre-tax profits generated are set aside to contribute to their employee’s retirement plans. Standard 401(k) contributions have the added benefit of being tax-exempt until the funds are withdrawn upon retirement.
Now that a basic understanding of what the 401(k) is has been established, a discussion of several key ways you can make the most of your 401(k) contributions will follow.
Choose the Rate That’s Best for You
When negotiating your 401(k) plan with your employer, a default contribution rate will generally be chosen, usually at around 3% of your gross income. Depending on your income level and your retirement ambitions, this default rate may be insufficient to ensure a comfortable retirement. If your goal is to maintain the same standard of living in retirement as you have while working, increasing your contribution rate is one of the simplest and most effective options.
Commit to small, annual increases in your contribution rate until you reach 15-20% of your net income in 401(k) contributions. Some companies have a limit to the rate of contributions they are willing to match, so consult with your employer before making the decision to increase your contribution rate.
Stay with Your Company Long Enough to be Vested
Each employer has different rules about how long you must work for them in order to claim the portion of your 401(k) comprised of company contributions. Generally, companies require staff to be on the payroll for at least 1-3 years before they are able to take advantage of company- matched contributions, but some companies may require as many as 5-6 years before the full balance of contributions can be claimed. This is referred to as vesting in your 401(k). If you leave the company before becoming fully vested in your 401(k) plan, your employer can forfeit the funds that were contributed to your 401(k) on your behalf. Ensure that you are well-versed in your company’s vesting schedule in order to qualify for their 401(k) matched contributions.
Diversify Your Portfolio
As your 401(k) investments suffer the same risk of loss as those found in standard portfolios, you must adopt the same mindset when protecting your savings. Since no one can predict to an absolute certainty how the market will behave from one day to the next, it is important to have well-diversified assets in order to weather volatile market conditions. This is especially the case with the 401(k) plan, as your retirement lifestyle will be constrained largely based on the ability of your 401(k) to retain its value.
Consider using your 401(k) to form your own mutual fund by investing in a range of companies from different economic sectors that you know well and trust.
Though the adage of not placing on your eggs in one basket still holds true here, you also don’t want to spread your assets too thin by investing in companies you know little about and lack the time to effectively keep up with. The ideal number of investments will range depending on several factors, such as your income level and the amount of time you are willing to devote to researching each investment opportunity, but a general rule of thumb is to keep the number of investments at around 20-30.
Learn to Navigate Fees and Penalties
All 401(k) plans limit the amount you are permitted to withdraw based on your age. Beginning in 2020, all 401(k) withdrawals before the age of 59½ are subject to a 10% early withdrawal penalty. There is also a penalty imposed if you wait too long to begin making withdrawals.
Also beginning in 2020, those over the age of 70½ must make required minimum distributions (RMDs) from their 401(k). If you fail to withdraw the minimum RMD amount, an additional 50% tax penalty is imposed on your withdrawals on top of the standard tax deductions.
To get the most out of your retirement, it’s important to keep up to date on the age requirements for all your retirement savings vehicles, including social security benefits, your 401(k), and any IRA contributions you may have, as these requirements tend to be updated periodically.
When calculating the taxes that must be deducted from your 401(k) upon retirement, it’s important to keep in mind what kind of 401(k) plan you have and how your income level affects your tax rate. Since deductions are made using the same tax brackets as standard income, the tax rate rises incrementally for higher tiers of income.
For regular 401(k) plans, contributions are deducted from your pre-tax, gross salary, so the tax deductions do not take affect until after you retire. Thus, the tax bracket you fall into is determined in the first year of your retirement, when you begin making withdrawals. This makes calculating your tax deductions a fairly simple process, as your distributions are taxed in the same manner as your standard income.
For a Roth 401(k), contributions are made from after-tax income, meaning that no tax deductions are made once you begin making withdrawals. This makes the Roth 401(k) plan ideal for those who believe they will occupy a higher tax bracket in retirement than they fall into while working.
Reaching your retirement goals may seem like a daunting task, but by taking advantage of the financial tools made available by your company’s retirement plan, and by understanding all of the options made available to you, reaching those goals can be made far more manageable.