Five Tips for Getting the Most Out of Your 401(k)

April 16th, 2019 by Jim Allen

Over the past 30 years or so, the 401(k) had become the standard for employee retirement plans. Before that, companies typically provided a pension or profit sharing plan and assumed all of the cost and risk of an employee’s retirement. However, since the bulk of 401(k) contributions come from an employee’s own contributions, and the employee is assuming all of the investment risk, employers realized that the 401(k) is a more cost effective way (for them not the employee) to help fund their employee’s retirement. Essentially, companies transferred all of the risk to the employee and have made them responsible for making sure they have enough to retire on.

While not as favorable to you as an employee compared to a pension, the 401(k) is likely going to be your major opportunity to put away money for your later years. For those of you who work for the government, are teachers, or work for a non-profit, you have similar vehicles in either 403(b) or 457 plans. For this week’s blog posting, we wanted to share some tips for getting the most from your 401(k).

• Contribute Enough to Get the Maximum Employer Matching Contribution:

Usually employers will make some sort of matching contribution for any contributions you make. This is typically capped at a certain percentage like 4% or 6% of income. The match may be 50% to 100% of any contributions you make, or some combination in a tiered formula. For example, the employer may match 100% up to the first 4% you contribute and then 50% on the next 4%. If you are not taking advantage of the employer match you are leaving a significant amount of money on the table. Consider the match as the only real employer contribution to your retirement in most cases.
Let’s look at example: If an employer matches 100% of the first 4% of your contribution and that amount is $5,000, then you have $10,000 contributed to your 401(k) growing tax deferred. That could be looked at as the same as a 100% return on your contribution. Those employer matches, compounded over a long period of time, can make the difference between a successful or stressful retirement.

• Keep Your Investment Allocations Up to Date:
When reviewing our client’s 401(k) statements, one of the more common issues we see is that the investment allocations are incomplete or out of date. The plan may have a money market account as the default investment choice and it isn’t unusual to see the employee’s account 100% in that money market as other choices were never selected. The other common issue we see is that the investment choices were selected long ago and the employee’s circumstances have changed. Your investment allocation should be reviewed at least annually and any other investments outside of the 401(k) need to be considered as part of your overall allocation.

• Take Advantage of Roth 401(k) Options:
A recent development in 401(k) plan design is to offer a Roth 401(k) option. The Roth 401(k) has different tax treatment than the traditional 401(k) and may be more appropriate depending on your stage in life and your tax bracket.
The traditional or regular 401(k) usually provides for pre-tax contributions of both your own money and the employer match. The contributions grow tax deferred and then you pay tax when you withdraw the money out of the account. So this is like not having to pay tax on the seed but then paying tax on the fruit. A Roth 401(k) is essentially the opposite where the contributions made are with after-tax money but is then generally tax free when withdrawn. So you paid tax on the seed but not on the fruit. Whether one is more appropriate than the other requires some detailed analysis around current and future income tax rates. Often, it may make sense to hedge your bets and contribute a portion to both.

• Be Careful About Taking 401(k) Loans:
Most 401(k) plans have an option to take a loan against your 401(k) balance. You will pay interest on the loan and, in most cases, the loan has to be repaid in 5 years or upon termination. This may look like an attractive way to borrow money as the rates are more favorable than some other types of loans, but there are some important risks to consider before taking a 401(k) loan.
First, the money borrowed will not be invested in your portfolio so you will miss out on the returns that the loaned funds could have made. So there is an opportunity cost that could negatively affect your retirement savings. Second, and more importantly, if you should leave the company or are suddenly laid off, the loan typically becomes due and payable at that time. If you don’t have the funds to repay the loan, then you will pay tax on the extinguished loan and potentially the extra 10% penalty tax if you are under age 59 ½. This makes the 401(k) loan more risky than other potential loan sources. Always consult with your financial advisor before making a decision to use a 401(k) loan.

• Make Sure Your Beneficiaries are Up To Date:
It is important to know that the beneficiary designation of your 401(k) will control who receives your account balance when you pass away. It isn’t that unusual for someone to have named a beneficiary (or maybe never named one) and then never updated it. If you have a life transition event such as getting married, divorced, widowed, or having children then your beneficiary needs to be updated. Also do not forget to review the beneficiaries of any 401(k) s from previous employers you may not have moved to your current 401(k) or rolled to an IRA. It is a good idea to do an estate plan update every year to make sure all your beneficiary designations are up to date.

Your 401(k) may likely be your most important retirement nest egg. Making sure you are doing everything to get the most out of this important employee benefit is critical to your retirement success. If you would like a complementary 401(k) review, please contact us to schedule your appointment.