7 Steps to an Awesome 401(k)

401k and retirement planning

Having an awesome 401(k) can be easy

The 401(k) plan could arguably be the single best retirement vehicle that savers and investors have at their disposal.  In fact, for many people, the 401(k) will make up a significant part of their retirement income.   Some studies suggest that Social Security will act as the single-largest retirement source for many.  One study suggests that by combining Social security with a 401(k) plan, a retiree may be able to replace up to 60% of their pre-retirement income.

Just how much of your retirement will be replaced by Social Security is dependent on a number of factors, but it’s fair to say that a 401(k) may play a major role in your retirement plan.

With so much riding on the success or failure of your 401(k), one would think that every saver would take the time to know the rules.  However, many employees continue to take less than full advantage of their employer-sponsored plan.  Some may not know enough to make an informed decision, while others simply choose to go in another direction.

That being said, for those seeking more information on how to best make use of their 401(k), here are several things you may want to consider.

Step 1 – Enroll as quickly as you can

When establishing a 401(k) plan, your employer may have the ability to limit eligibility to the plan.  For example, they may say that you are immediately eligible to participate.  Some plans, on the other hand, may make you reach one year of employment prior to becoming eligible to participate.

The first step is knowing precisely when you become eligible. Once you are eligible, you should consider enrolling immediately.  When you enroll, you will need to complete the following

  • Open an account
  • Select a deferral percentage
  • Select an investment (see below for more information)
  • Name a beneficiary (if you were to die, who do you want to get your money?).

It’s that easy! Your HR department or someone at your office should be able to point you in the right direction.  By enrolling immediately, you can begin investing and start putting time on your side.  The more time you have on your side, the greater the potential impact of compound interest.

(Note: some employers do not offer auto enrollment.  With auto enrollment, your employer will automatically enroll and defer a percentage for you, unless you opt out.)

Step 2 – Take advantage of free money

Many, but not all, employers will match contributions to your 401(k) plan.  If your employer does match your contributions, it often makes sense to contribute at least up to the amount of the company match (some employees don’t do this).  It’s free money, after all!  A company match acts as an immediate rate of return on your money.

Just how much they match is up to the employer.  Some employers choose to match dollar for dollar up to a stated percentage, hypothetically, let’s say 4%, of your contribution.

If you make $100,000 and contribute 4%, that is a $4,000 annual contribution.  If your company has a  match of 4%, as stated above, then they would pitch in another $4,000.  That’s a free $4,000 just for participating in the plan.

Step 3 – Pick an investment and stick to it

One of the more difficult decisions to make with a 401(k) plan is the decision of where to invest your money.  Often, your 401(k) will offer several investments to choose from, including individual mutual funds (for a “DIY” personality) and target date funds (for a “do-it-for-me” investor).

Individual mutual funds can be used by an investor who is looking to make their own decision on where and when to invest.  This option is often used by someone who is seeking to take an active role in their own money management.

Target date funds may be suitable for someone who isn’t exactly sure what to do.  These funds offer a diversified portfolio* at the push of the button.  The risk tolerance is loosely based on the age at which you plan to retire.  If you plan to retire in the short term, then the target date fund is invested in a more conservative portfolio. If you plan to retire in many years, the target date fund will be invested more aggressively.

However, not all target date funds are created equally.  Each money manager has a different take on what investments are suitable for an investor of a particular age or profile.  Therefore, while target date funds can offer an easy solution for those seeking a diversified portfolio*, it’s important for the investor to continue reviewing the fund for suitability.

The key here, regardless of which selection you choose, is to stick to your investment.  401(k) investments are intended to be long term in nature.  Markets will be volatile in the short term and volatility may cause you to react accordingly.  However, studies suggest that in the long run, investors who stay invested tend to outperform those who attempt to get in and out of the market quickly.

Step 4 – Participate in auto increase

Being successful with a 401(k) plan may be the result of continuing to increase your contributions over time.  The more you save, the greater the likelihood of having a higher account balance upon retirement.

One way to save more is to manually increase your 401(k) deferrals over time.  For example, you can review your 401(k) each year and manually increase your deferral by a small percentage.

Unfortunately, this step is often overlooked, as life tends to get in the way.

A better option may be to participate in the auto increase option, if your 401(k) allows.  With this option, you elect to automatically increase your deferral percentage each year.  For example, if you are contributing 10% today, the system will automatically increase the contribution to 11% next year.

This auto increase occurs without you having to move a muscle.  Ultimately, this forced savings might mean a larger savings bucket when retirement arrives!

Step 5 – Consider the ROTH option

401(k) plans of the past only offered a traditional 401(k) option.  The traditional 401(k) plan takes pre-tax dollars and defers them into your retirement plan account.  The result of a pre-tax deferral may be  an immediate tax savings.

When you withdraw funds from a traditional 401(k) plan, all the distributions are taxed as ordinary income (assuming they were all pre-tax contributions).

A ROTH 401(k) is essentially the exact opposite.  When you defer money into a ROTH 401(k), you pay the tax now.  When you withdraw money later, it is all tax-free (assuming qualified withdrawals).

A ROTH 401(k)can be a great option for many reasons.  Some of these may include:

  • You are in a low tax bracket
  • You are young and have time on your side
  • You are looking to diversify the types of retirement dollars you have (you already have too much invested with pre-tax dollars)
  • You are looking to pass this on as inheritance

In addition, contributions made on behalf of a company match or a profit share will be pre-tax dollars.  So if you contribute to a pre-tax account and your company contributes on your behalf., you will end up with pre and post tax savings.

Step 6 – Avoid the temptation to tap (loans/withdrawals/distributions)

A big concern with contributing to a 401(k) is access to the money.  Simply put, what if I need it?  The short answer is you should resist the urge to tap into your 401(k).  This is money that is earmarked for later in life, and if you access it now, it will not be around for later.

The longer answer is that the 401(k) plan document established by the employer will dictate just how much access you have to your contributions.  However, 2 options commonly exist. The first option is a loan, which allows you to borrow up to 50% of the account balance up to a maximum of $50,000.

Secondly, you can make a withdrawal.  A withdrawal, especially a withdrawal before age 59 1/2, will likely mean ordinary income taxes plus a penalty on your distribution.

Another critical time for a 401(k) is when you leave your job.  When you leave your job, the 401(k) is often thought of as a place for easy access to money.  Unfortunately, distributions may be subject to the same tax and penalty mentioned above.

A better option may be to process a non-taxable rollover to an IRA.  A non-taxable rollover to an IRA means the money remains tax-deferred and available for the long-term plan, i.e. retirement.

Step 7 – Know your advanced options

Several special provisions exist in 401(k) plans that often go overlooked.

The first of these is specifically for those who retire from a company at 55 years of age or older, but prior to 591/2.  If you fall into this bracket, it may make sense to leave your 401(k) in place, as opposed to rolling it into an IRA.

The IRS has a special provision that allows penalty-free distributions from a 401(k) plan for those who retire at 55 years of age and older, but prior to age 591/2, without incurring a 10% penalty.

This penalty-free withdrawal option does not exist for investments in an IRA, so if you choose to roll the money to an IRA, this liquidity vanishes with the rollover.

The second advanced planning option is net unrealized appreciation.  If you have highly appreciated company stock in a 401(k), you want to learn more before doing anything.  It’s possible to withdraw your highly appreciated stock and claim ordinary income on the basis, while paying long-term capital gains on the profit.

Now what?

A 401(k) may be a big part of your financial and retirement plan.  If you are just getting started, a 401(k) may be a good place to start.  If you already have one, now may be a good time to take a hard, honest look at your choices thus far, which might put you in a better place years down the line.


*Diversification does not guarantee a profit or protect against a loss.

Actual investment return and principal value of mutual fund investments will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Investments in Target Date Funds are subject to the risks of their underlying funds.  The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce.  The principal value in a Target Date Fund is not guaranteed at any time, including on or after the target date, which is the approximate date when investors turn age 65.  Should you choose to retire significantly earlier or later, you may want to consider a fund with an asset allocation more appropriate to your particular situation.  The funds invest in a broad range of underlying mutual funds that include stocks, bonds, and short-term investments and are subject to the risks of different areas of the market. The funds maintain a substantial allocation to equities both prior to and after the target date, which can result in greater volatility.

Prior to rolling over assets from an employer-sponsored retirement plan into an IRA, it’s important that you understand your options and do a full comparison on the differences in the guarantees and protections offered by each respective type of account as well as the differences in liquidity/loans, types of investments, fees and any potential penalties.

A plan of regular investing does not assure a profit or protect against loss in a declining market.  You should consider your financial ability to continue your purchases over an extended period of time.

None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

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