5 Common Questions About Your 401(k)
The 401(k). It’s one of the staples of financial maturity for anyone who has one or is starting to think about participating in one. It’s a promise to your future self that you’re willing to give up present gratification for future stability. It is a savings instrument that was created to make the public responsible for their retirement savings. The retirement landscape that our parents and grandparents were used to has changed. Very few companies offer a pension to reward an employee for years of hard work, loyalty, and service. The 401(k) gives us full control of our future; sounds good, right?
With more control over our future and as I continue my career as a financial planner in the Rio Grande Valley, I’ve found that the 401(k) has some lingering questions from anyone who has one or is thinking of participating in one. Questions like:
Should I participate in a 401(k) or a Roth 401(k)?
How much should I save?
How do I invest it?
When can I take money out of it?
What happens when I leave my employer?
A bit of disclosure as you read on. Everyone’s situation is different, and you should consult with a financial adviser if in any doubt.
401(k) vs. Roth 401(k)
Both are employee sponsored retirement plans, both allow employees to contribute up to $18,000 in 2016-2017, and both have required minimum distributions by age 70 ½. The difference? Tax treatment. The traditional 401(k) allows you to report a lower wage by giving you a deduction for the current year. Example: If someone makes $50k and contribute $5k to their company’s 401(k), then their reportable income is $45k. On the other hand, the Roth 401(k) uses after-tax money. If that same person makes $50k, their reportable income doesn’t change, it’s still $50k.
However, if someone uses a traditional 401(k), any distributions from their account are taxed when they are distributed because taxes were delayed. While any distributions for a Roth 401(k) have already been taxed, so any distributions are tax-free. So which one is right to use? That answer depends on your personal situation. As a general rule of thumb, if you pay little to no taxes, the Roth 401(k) would be best option for you.
How much should I save?
This questions is also tricky to answer. I’m a firm believer that you should have a solid foundation before you start investing. What I mean by that is, you should be properly insured for your life stage, have at least a month’s salary saved up in an emergency fund, and have a solid budget in place. Once those things are in place, re-visit your budget and reallocate a sum that you’re comfortable living without (remember you can’t access 401(k) money without a penalty before age 59 ½). When I started saving in my 401(k), I made sure that I had some “fun money” available in my budget because if I didn’t, I knew I would cut back on my 401(k) savings anyway.
How do I invest my 401(k)?
Typically, 401(k) investment options are limited. I’m a firm believer in capturing the stock market and diversifying your investments. My rule of thumb for anyone starting to participate in their 401(k) with less than $10k is to use a target date retirement fund. A target date retirement fund is a mutual fund that essentially exposes the investor to more risk during the investor's youth and adjusts itself to a conservative allocation as the investor grows older.
Another approach that can be taken in case the investor doesn’t want to be overexposed in stock, is investing in a balanced fund. A balanced fund is a mutual fund that also has a set allocation of stocks and bonds but stays static. Meaning that it does not adjust itself over time like the target date retirement date fund. For this to be an effective strategy, it would be wise for the investor to take a risk tolerance questionnaire and find out what an appropriate balance fund is for their risk tolerance. Vanguard offers a free tool to help measure your risk tolerance.
When can I take money out?
Generally speaking, you cannot take money from your 401(k) until you reach the age of 59 ½ without a penalty from the IRS. There are certain instances that will qualify as an exception to the penalty if the investor decided to withdraw money from their 401(k) before the age of 59 ½. Again, you should consult with a financial adviser before withdrawing funds from your 401(k).
What happens if I leave my employer?
Our generation is estimated to have at least four jobs in their lifetime and if you’re anything like me, you may have had double that amount. So what happens to your 401(k) when you leave a job or lose it. Well there are a few options.
The first option is to leave it there. If the expenses on your 401(k) plan are low and your previous employer allows it, just leave it there. The money still belongs to you.
The most common option is to roll it out of your previous employer’s 401(k) plan into another account called an Individual Retirement Account (IRA). If you decide to do this, do not forget two important things. The first is to open an IRA account with another bank/custodian and have your previous employer send THEM a check directly. If the check is made out to you, there is a 20% withholding from the check mandated by the IRS so you won’t be able to fully invest all of your funds. The second thing not to forget is to ACTUALLY INVEST your money. Remember, your new bank is just getting a check. It’s up to you to have it invested.
The last option is to roll your old 401(k) account into your new employer’s 401(k) account, IF THE PLAN ALLOWS. Before doing this, make sure that the fees on your new employer’s 401(k) are equal to or less than your old employer’s plan. Why would you want to pay more money to invest the same amount?
MyLife Financial is a fee-only financial advisory firm providing objective and independent advice virtually. Our clients are busy professionals that face daunting questions of how today's financial decisions will affect their long-term financial success. Everything written is strictly for informational use only. Please seek the advice of your CPA, Attorney, or financial professional before implementing any strategies.
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