What You Need to Know About Your 401k
Most of the people I talk to about saving for retirement tell me they arbitrarily pick investments for their 401k, rarely look at their balance and performance, and have no idea what they are paying in fees and expenses. I get it. Statements can be difficult to understand and it’s unfair that your company expects you to know what’s best for your retirement plan. I’ve probably mentioned in previous posts, but the burden of saving for retirement and choosing proper investments used to be on the companies themselves. Unfortunately, the business world migrated from pensions to 401k’s, and individuals were not given proper guidance and training as to how to invest for their future.
So here’s what you need to know about your 401k:
Expenses and fees:
Your employer-sponsored retirement plan is not free. Many plans divvy up administrative and record-keeping costs among participants and it can be difficult to know exactly how much you’re paying. Often these fees aren’t listed on your statements either.
If your 401k investments are in mutual funds or ETFs (very likely), you’re also paying an expense ratio. An expense ratio is an annual fee they charge their investors. Expense ratios include 12-b1 (advertising) fees, management fees, operating costs, and others costs incurred by the fund. Basically, it’s what it costs the investment company to operate the mutual fund. The next time you get a statement, I would recommend you look up each mutual fund and/or ETF included in your 401k (you can do this through AOL Finance, Yahoo Finance, Morningstar, etc). Among all the information included about the fund, you’ll see “Expense Ratio” listed somewhere on the page. The goal is to be invested in mutual funds and ETFs which have an expense ratio less than 1%. If after your research you find your average expense ratio is higher than 1%, you may want to talk to your plan administrator about finding less costly funds. The expense ratio is very important. This often over-looked percentage can drastically eat away at your earnings over time. The lower your expense ratio the better.
If you are unsure about your 401k fees and expenses, just ask! Have your HR rep or plan administrator break it down for you. It’s your right to know.
You must know if your company has a matching policy. If so, how much do you need to contribute to qualify? And what is the maximum match? You should at least be contributing enough to get the match. This is free money. Don’t ever leave free money on the table! Matching contributions will also significantly boost your savings over time. Your company may also do profit sharing which is different than a company match. It’s important to find out if your company does one or the other, both, or neither.
The vesting schedule determines how much of your 401k you’ll keep when you terminate employment. When discussing retirement plans, vesting is another term for ownership. When you vest, you are obtaining the legal right to keep the contributions. While your own contributions are always 100 percent vested, your company’s matching contributions may not be. Some employers offer immediate vesting, which means you automatically own 100 percent of employer contributions to your 401k. Other employers may offer graded or cliff vesting schedules.
A graded vesting schedule means you’ll gain a certain percentage of irrevocable rights over employer contributions, usually on the anniversary of your employment. You’ll become at least 20 percent vested initially following a period of service (could be upon your start date, after one year, or even two years). You’ll gain another 20 percent each year until you’re fully vested.
A cliff vesting schedule means you’ll be zero percent vested for an initial period of service, but once you reach the required length of employment, you’ll be 100 percent vested.
How much of your pre-tax salary are you contributing toward your retirement plan? Is it enough? Normally, people measure their contributions as a percentage of their salary. For example, you could be putting five percent of your pre-tax salary into your 401k. Ideally, you should be saving about 15 percent of your pre-tax pay for retirement, but if you increase your contributions by one percent each year, you’ll get there eventually. Remember, contributing what you can is better than not contributing at all. You can contribute up to $18,000 in 2017, and if you’re over 50, you can throw in an extra $6000.
Be cognizant of how much you’re contributing!
It’s advantageous to know if your retirement plan offers a Roth option. The difference between a Traditional 401k and a Roth 401k is the timing of the taxes. With a Roth 401k, you’ll pay taxes up front. This means the money you contribute is taxed now instead of taxed when you withdraw in retirement. If you’re in a lower tax bracket now, this is a great strategy. You’ll pay lower taxes now, the money will grow tax-free, and you’ll withdraw tax free when you’re retired. You might be able to contribute some to a Roth 401k and some to the traditional as well.
The allocation and diversification of your 401k is crucial to you reaching your retirement goals. The allocation refers to how much of your portfolio is in equities, fixed-income, and cash and cash equivalents. Your asset allocation will determine how risky your portfolio is. You want to allocate based on your goals, time-horizon, and risk tolerance. Diversification takes it a step further. Within your allocation, you’ll pick various investments so you’re spreading your eggs in many baskets. Diversification will help you achieve your goals and lessen the amount of risk you’re taking within your 401k.
Achieving proper allocation and diversification isn’t as difficult as I probably just made it seem. If you need help, consult with a financial planner or at least do some Googling. Honestly, you don’t need a million fancy investments, a good mix of a few index funds and ETFs can usually get the job done.
There’s a few ways you can be penalized within a 401k. If you withdrawal from the account prior to 59 1/2 years old you’ll be taxed at your ordinary income tax rate plus a 10 percent penalty. With traditional 401k’s you are required to take a minimum distribution (RMD) by April 1st following the year you turn 70 1/2. If you don’t take the RMD in time, you may have to pay a 50 percent excise tax on the amount that should’ve been distributed. Finally, if you go over the contribution limits, you could be taxed twice on the excess contributions and possible penalized with the 10 percent early withdrawal penalty.
I’m noticing now this article is not at all entertaining and I’ve rambled on too long. I really do feel like this information is critical to your future success and I don’t want you to have to eat cat food in your old age.
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