Your Guide to Investing in a 401(k)
How to make the most of this common retirement account.
The 401(k) has been a part of retirement planning for decades, and if you’ve had an employer who has had a plan, you might have had the opportunity to invest in a 401k.
Even still, you might not understand it completely, and that’s ok because there is a lot to understand with it comes to your 401(k).
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Let’s break down everything you need to know about investing in a 401(k) from how it works to what you need to consider to get the most out of your plan.
What is a 401(k)?
A 401(k) is a retirement savings plan that some employers offer, and it provides tax advantages to employees. The plan was developed by Congress to encourage Americans to save for retirement, and it is named after part of the U.S. Internal Revenue Code: Section 401, subsection (k).
Briefly, here’s how a 401(k) works:
First, when you get paid, you contribute a portion of your income to your 401(k) account.
If your employer offers a 401(k) match, and you put in enough money to qualify for it, then they’ll also contribute some money to your 401(k) account.
Next, after putting money in your 401(k), you can grow it by making several investments, which usually consist of stocks, bonds, or mutual funds.
Once you are 59.5 years old, you can start withdrawing this money without paying a penalty.
Ways to Invest Your 401(k)
There are different ways to invest your 401(k), and there are two types of accounts:
Traditional 401(k)
Roth 401(k)
A traditional 401(k) is where you make contributions that are pretax. At retirement, you pay taxes on every withdrawal you make. This amount could add up to hundreds of thousands of dollars, depending on your tax bracket and tax rates at the time.
A Roth 401(k) is an account where you invest your after-tax income. This means that when you withdraw money from a Roth 401(k) after your retirement, you don’t need to pay any taxes. Any employer contributions (or matches) must go into a pretax account and are taxed when distributed.
For a Roth 401(k), at retirement age, since it isn’t included in income, distributions won’t affect your Medicare premiums. Also, an added benefit is that, as part of an estate, the benefits of the Roth 401(k) flow directly to the beneficiaries.
Before starting your 401(k) account, you get to choose between the traditional account or the Roth 401(k). So, which one should you choose?
If you currently belong to a lower tax bracket but expect to be in a higher tax bracket after retirement, the Roth 401(k) might be the best option for you as it will help you save money in the form of lower taxes. However, if the reverse is true, go for the traditional 401(k).
Why contribute to both (if your company allows you to do so)?
It’s another way to diversify your retirement funds.
You can benefit from each plan's unique tax advantages.
For example, you can alternate months or years between:
Making contributions to your Roth 401(k) and benefiting from tax-free withdrawals later in life.
Contributing to your traditional 401(k) and enjoying reduced income taxes now.
If you contribute to both, remember that the limit is $20,500 (or $27,000 if you're 50 and above) for ALL your 401(k) accounts, combined.
So, no matter what type of 401(k) plan you invest in, you can rest easy knowing that your post-retirement life will be taken care of.
Why Invest a 401(k)?
You might be thinking…
Why would I want to take a cut out of my paycheck right now?
Well, if you know anything about DIYwealth, it’s that the importance of preparing for retirement cannot be overstated.
And this preparation becomes easier with a 401(k), because the plan automatically transfers contributions from your paycheck to your account, and those contributions grow through your investments.
However, there are other benefits of a traditional 401(k), and these benefits include:
Reducing your income taxes: You don’t owe income tax on the portion of your paycheck that goes to your 401(k) as long as you leave the money untouched in your account. This contribution then reduces your total taxable income!
Saving on taxes for any profits you earn from your investments (for now): So, let’s talk about those mutual funds and ETFs that make up your 401(k) investments. You don’t have to pay taxes on any dividends, interest, or profits you earn from them until you withdraw your money at age 59.5.
Getting “free” money from your boss: Who wants to leave money on the table? If your boss offers to match a percentage of your 401(k) contributions, take it! It might not seem like a lot right now, but with the magic of compound interest, it really adds up.
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Drawbacks & Downsides to Investing in a 401(k)
These benefits of a 401(k) sound great, but investing in a 401(k) might not be for everyone.
(Also, it shouldn’t be your only plan for retirement. Remember to diversify!)
Here are some downsides to consider:
You could pay more taxes once you retire: You’re taxed on any gains the account makes. And no one knows if you’ll be in a higher tax bracket when you retire, which might cause you to pay more in taxes.
You have less control over your investments: Some company plans lack variety or good investment choices. Also, due to processing times, you can’t always change your 401(k) investment plan easily. With a 10% withdrawal penalty rate plus taxes, you’re also discouraged from touching your money before retirement (with the exception of extreme hardships and huge medical bills).
Your 401(k) plan might be too expensive: Some company plans come with painfully high fees. We will talk more about fees below, but this cost can add up over time and eat into any profits from your 401(k).
What is a 401(k) Match?
Now that you have a broad overview of what a 401(k) is, let’s talk about 401(k) matching. Basically, it’s when an employer contributes a certain amount to your savings plan based on your annual contribution.
You’ll want to find an employer who:
Can offer you a high 401(k) match (more on this below).
Has a reasonable 401(k) plan vesting schedule.
The vesting schedule determines how long you need to work for your boss before you get to own your employer’s 401(k) contributions, which is five years on average.
This means that if you leave your job before five years, you might not get to keep your employer’s contributions. You still get to keep any contributions you’ve made, though.
Here’s how 401(k) matching works:
Let’s say you earn $50,000 a year, and you contribute 7% of your annual salary to your 401(k). This means that $3,500 goes to your 401(k).
Now, 401(k) matches vary greatly from company to company, from very generous matching to zero matching at all. If your boss follows the most common 401(k) match formula, then they contribute 50 cents for every dollar you contribute up to a limit of 6% of your pay. This is called partial matching.
Partial matching simply means that another $1,750 goes into your account. This amount is all pre-taxes, and it’s on top of existing income and any bonuses you might receive.
Altogether, that’s $3,500 + $1,750 = $5,250 contributed to your retirement savings for the year.
Another kind of matching is known as dollar-for-dollar matching.
Let's use the same annual income example of $50,000. Let’s also say you contribute 7%, which is $3,500, to your 401(k).
If your boss does dollar-for-dollar matching, they contribute 100% of what you contribute, capped at 5% of your annual income, which is $2,500. So $3,500 + $2,500 = $6,100 goes into your 401(k) each year based on this matching formula.
And regardless of the kind of match you get, make sure you’re contributing enough to get the maximum match from your employer.
401(k) Considerations Before You Invest
Before investing: Create a budget, an emergency fund, and pay off any urgent credit card debts if you can. This way, you will know how much money you can set aside from your paycheck to invest in your 401(k).
Calculate your retirement needs with this handy calculator. This process will give you a bigger picture of exactly how much you will really need to retire.
Find out your risk tolerance.
One way to calculate your risk tolerance is:
100 - [your age] = how many % you should invest in stocks, which are a riskier investment than bonds.
You also have to be honest with yourself: Are you willing to accept more risk for higher returns?
Decide your timeframe: How long are you willing to wait before taking money out of your 401(k)?
Remember, keeping your money in your 401(k) longer allows you to enjoy higher returns over time.
It also gives you more time to recover from any high-risk investments you might make.
Know your options: A typical 401(k) plan gives you at least 10 or more options to choose from, including:
Mutual funds, which allow a group of investors to pool money to invest in securities like stocks and bonds.
Exchange-traded funds (ETFs), which allow investors to buy many securities in a basket all at once.
Choose wisely: Check what Morningstar.com says about your options, in terms of:
How the fund has performed over 5-year and 10-year periods in terms of returns (not just in the last year!)
The fees, especially the expense ratio. This figure refers to how much you have to pay for investing in a certain fund. Shoot for an expense ratio of below 1%.
Its risk rating and how the fund is allocated between stocks, bonds, and commodities. Does it meet your risk tolerance?
Diversify your portfolio: Simply put, you don't want to put all your eggs in one basket. Try spreading them out across different baskets (asset classes, market caps, sectors). This move will allow you to do the following:
Increase your returns in the long run.
Reduce and balance out your risks.Don't want to do all that research? Try these options:
Target-date fund: All you have to do is select your "target" retirement year and risk tolerance. The fund will automatically change its mix of stocks and bonds to take less risk as you approach retirement age.
Roboadvisor: These online financial advisors, such as Blooom, use advanced algorithms to manage your 401(k) for you, including asset allocation and rebalancing.
How to Contribute to Your 401(k)
First, find out how much you can contribute to your 401(k) each year.
All this depends on:
Your salary and the company plan you’ve chosen (as discussed above).
The latest government regulations.
The Internal Revenue Service (IRS) determines the limits on your 401(k) contributions each year, depending on the rate of inflation. These limits can change every year. For instance, in 2021, the 401(k) limit was $19,500.
Now, in 2022, the new limits for your own total yearly contributions to all your 401(k) accounts are:
$20,500 if you're below the age of 50.
$27,000 if you're 50 or older, which represents a $6,500 catch-up contribution. (We will talk more about catch-up contributions below.)
Additionally, the 2022 limits on employer and employee contributions combined are:
$61,000 if you're below the age of 50.
$67,500 if you're 50 or older.
Second, decide how much you wish to contribute to your 401(k).
In 2020, according to the latest figures, Americans contributed 7% of their pay on average to their 401(k). Factor in employer contributions, and this number goes up to 11%.
But, specifically, how much should YOU contribute?
This question depends entirely on how much you think you'll need in retirement. Again, you can calculate this for yourself based on your own financial goals.
Experts say you should contribute:
10% or more of your income toward retirement (including any other accounts you might have).
And as much as you can to your 401(k) to get the maximum employer match, so you don't leave free money on the table.
A strategy you can use is just starting with a smaller contribution, or just enough to get the match, then slowly contribute 1-2% more to your 401(k) each year.
Withdrawing Money from a 401(k)
As we discussed above, when you reach the age of 59.5, you can start withdrawing money from your 401(k) without any penalty. However, the amount you withdraw will be counted as income, and you will have to pay taxes on it.
It is possible to withdraw money from a 401(k) before retirement age. But you will have to pay a hefty price… a 10% early withdrawal penalty plus taxes on all the funds. On huge sums of money, the penalty adds up to be quite significant.
For example, let’s say you have $300,000 in your 401(k) account, and you need to withdraw the money early. This means you’ll lose out on $30,000 due to the early withdrawal penalty alone. Not to mention the taxes you have to pay if it’s a traditional 401(k) account. So, don’t take out money from your 401(k) unless it is an emergency, and you have no other option.
Some employers also allow something known as a “hardship withdrawal” when you’re in need of a hefty sum of money due to unforeseen circumstances such as medical or funeral costs, education fees, or to avoid foreclosure against your home. For this type of early withdrawal, you won’t be charged a penalty, but taxes will apply.
Another way you can withdraw money from your 401(k) when you’re in a bind is to take out a loan against your own contributions to the account. This means you are borrowing from yourself. However, this can be done only if your employer allows it.
The interest rates for these loans tend to be a point or two higher than the prime rate, but this is okay because you will be paying the interest back to yourself. You can either borrow $50,000 or 50% of your total 401(k) amount, whichever is the least amount.
The cons of taking out a loan on your 401(k) is that if you lose your job, you’ll have to repay the loan amount in full within a certain period of time. If you’re unable to do so, then you’ll be charged a 10% penalty + taxes.
Required Minimum Distributions
We’ve talked about how the minimum age to withdraw from your 401(k) without any penalty is when you’re 59.5 years old. But what happens if you don’t withdraw any money two, five, or 10 years after retirement?
You can go without withdrawing any money until you’re 72, and nothing will happen. But after you reach 72, the IRS will ask you to withdraw a certain percentage of money from your 401(k).
These withdrawals are called “distributions,” and the amounts are known as “required minimum distributions.”
When it comes to a Roth 401(k) account, you need to hold the account for a minimum of five years before your distributions can be considered “qualified.” Only then can you begin withdrawing money tax-free.
How to Self-Manage Your 401(k)
A typical 401(k) leaves you with fewer choices to choose your own investments. If you want more control over your investments, it might be a better choice for you to manage your 401(k) yourself.
Many employers offer something called a self-directed 401(k), also known as a brokerage window function, that allows you to control the investments in your 401(k) plan yourself. Under this plan, you have a wider selection of investment options including non-traditional options like real estate, gold, and even foreign currency.
However, the cons of a self-directed 401(k) are that you would need to manage everything yourself. So, here are some tips to help you on this journey.
Learn the basics of investing. This is crucial because it will help you understand fees, calculate your risk tolerance, and choose the best investment options.
Don’t stop contributing to your 401(k) unless it’s an emergency and you have no other choice. For example: missing out on a contribution because you had a medical emergency? Understandable. But putting a halt on your contributions because you want to save up for a vacation? No.
Stay on top of your funds and keep maintaining your portfolio. If you find this too difficult, you can hire a financial advisor.
401(k) Catch-Up
The IRS puts a cap on the amount you can contribute to your 401(k). It changes every year depending on the cost of living. In 2022, the maximum contribution is capped at $20,500. The same limits apply to Roth 401(k) accounts as well.
But, there is good news. This limit is only for people under the age of 50. Those over 50 are allowed to make extra contributions known as “catch-up contributions.” This is to help them catch-up on their goals and save up a nice nest egg before retirement. But, even if you aren’t behind on your saving goals, you can still make catch-up contributions.
In 2022, the maximum catch-up amount set by the IRS is $6,500 per year. If you contribute this extra amount regularly, it may have a significant positive impact on your final retirement amount! Catch-up contributions are taxed in the same way as normal contributions.
401(k) Fees
You do have to pay 401(k) fees, and as many as 41% of people don’t even know that they’re paying them.
Think about it. A 401(k) provider must be making something off of maintaining everything, right? That “something” is a small fee that they charge you every month. But, over time, this “small fee” adds up to a large amount of money.
401(k) fees come in three different types:
Investment fees. These constitute the largest portion of the fees and cover the cost of managing all the investments in your 401(k) plan.
Administration fees. Someone out there must be managing your 401(k) account whether it is a bank or a third-party financial service. This fee is to cover the administrative expenses such as record keeping, accounting, and legal services.
Individual service fees. Let’s say you made use of additional services such as opting for a brokerage window, taking out a 401(k) loan, or rolling over your 401(k) to an IRA. In such cases, you will be charged additional service fees, payable only by you.
An average person ends up paying 1-2% in the form of fees on their 401(k) account in their lifetime. It may not seem like much, but they make a huge impact on your savings. The Center for American Progress found that a typical worker who starts saving at the age of 25 ends up paying somewhere between $42,309 and $166,420 in fees alone! For high income workers, this amount triples.
That’s quite a lot of money. Unfortunately, there isn’t much you can do about it. It is a price you have to pay. If you take charge of choosing your own investments, you may be able to save a little amount on fees by choosing ones with a lower expense ratio. But, don’t try to compromise your investment goals by running behind low fees.
401(k) Alternatives
A 401(k) is a great vehicle to save for your retirement. But not everyone has access to it. For example: You may be self-employed or your company might simply not offer a 401(k) plan. Here are some great 401(k) alternatives:
Traditional and Roth IRAs. An IRA is an Individual Retirement Account that also offers tax advantages when it comes to retirement accounts. With an IRA, you can invest in anything, be it real estate, mutual funds, stock, bonds or ETFs, to name a few. But the drawback is that you can only contribute a maximum of $6,000 annually ($7,000 for those over 50).
SEP IRAs. A Simplified Employee Pension IRA is a great fit for those who run a business or are self-employed. They are very similar to traditional IRAs but have a higher contribution limit of 25% of your income or $61,000 for 2022 (whichever is lesser).
Solo 401(k). If you have your own business, you can take advantage of the solo 401(k) account although you’ll have to play the part of both employer and employee and contribute both sides of the amount. Unlike the employee-sponsored 401(k) plan, you can take your pick of investments. But if your business scales up and you end up hiring employees, having a solo 401(k) as an alternative can complicate things.
Can You Have a Roth IRA and a 401(k)
Yes, you can have a Roth IRA and a 401(k). But first, you need to understand that a Roth IRA has certain conditions, and you need to be eligible to contribute to both simultaneously.
As we saw above, a Roth IRA is a type of Individual Retirement Account. When it comes to a Roth IRA account, your contributions will come from your post-tax income, so your withdrawals won’t be taxed. Roth IRAs also don’t have required minimum distributions.
The drawback is that Roth IRAs have maximum contribution limits ($6,000 annually) and are available only to individuals who make less than $129,000 per year. For married couples who file taxes together, this amount increases to $204,000. That means you cannot open a Roth IRA at all if your income exceeds this amount.
Bottom line: If you’re eligible, you can have both a Roth IRA and a 401(k). It can be an effective strategy in building your post-retirement life.
Hopefully this guide helps you on your journey to investing in a 401(k). It’s true that there is a lot to consider, but making the first step toward planning for your retirement will help you in the long run, and that’s what’s most important!