Review your 401(k)
Last updated: January 1
It's never too early to start planning for retirement. A well-planned retirement can spell the difference between comfort and struggle in your later years. Many employers no longer offer company managed pension plans, but rather provide 401(k) retirement plans that allow you to choose where your investment dollars go. It typically takes some effort to ensure maximum returns.
What should you do?
Your 401(k) needs to be reviewed to ensure proper allocation of your retirement funds. Be sure to consult a financial professional should you have any questions.
First, how does a 401(k) work?
A 401(k) is a retirement savings plan sponsored by an employer, explains the Internal Revenue Service (IRS). If you participate in a 401(k), a portion of your wages or salary is paid into a retirement plan. Your employer may also make an additional contribution. The IRS sets limits on the amount you can contribute to your 401(k) each year. Your employer may also set limits.
Although your plan administrator sets up your 401(k) plan, you can choose how to invest the money. Your plan will generally give you a number of investment options to choose from.
Investing in a 401(k) can have significant tax advantages, listed by the U.S. Department of Labor. You generally don't pay income tax on money you contribute to a traditional 401(k) until it's withdrawn, explains the Financial Industry Regulatory Authority (FINRA). Also, while your money is in a 401(k), you don't pay taxes on the income your investments are earning for you.
Some employers may offer a Roth 401(k), the IRS explains has different tax rules.
Why should you review your 401(k)?
- Financial markets are constantly changing
- Allows portfolio optimization
- Enables risk exposure to be altered for improved performance
- Aids tracking of investment growth/loss
- Allows asset allocation changes from equities to low risk investments, like blue chip corporate bonds
How often should you review your 401(k)?
There are several schools of thought when it comes to re-balancing your 401(k) plan, according to the New York Times:
|Automatic||This is a standard feature of some 401(k) plans. This type of 401(k) plan will automatically re-balance at a given date. It is optimal if you have already set up the proper investment mix.|
|Indicator-based||This means whenever your statements reveal your 401(k) is down by a certain percentage — 5 percent, for example.|
|Professionally managed||Online brokers provide professional review and rebalancing of your 401(k)for a fee. There are several low-cost services that will provide this for you.|
|Time-based||This means reviewing and re-balancing your 401(k) at specified time periods. For example, mutual fund giant Vanguard recommends that you review your 401(k) once or twice a year.|
4 ways to get the most out of your 401(k)
If you have an employer who offers a 401(k) plan, taking full advantage can be one of the easiest, and smartest, retirement moves you make. Here are four ways to help you get the most out of your employer's 401(k) plan:
- Start saving for retirement as early as possible
- Don’t pass up matching contributions from your employer
- Avoid withdrawing, if possible
- Reassess if you change jobs
Start saving as early as possible
Time can be a critical factor in the returns you earn from your investment in your 401(k), says the Securities and Exchange Commission (SEC). Even if the amounts you can invest in a 401(k) seem small to you, they can make a big difference to your retirement fund if they're earning returns over decades.
Don't pass up matching contributions
Many employers match employee contributions to their 401(k) accounts. If you put a percentage of your salary into a 401(k), an employer may also put in a percentage, up to a certain limit.
FINRA puts it bluntly: "If you contribute less than your employer is willing to match, you may be passing up free money." If your circumstances allow it, you may want to consider making sure your 401(k) contribution meets your employer's matching limit.
The IRS explains that your employer's contributions may vest gradually, meaning those contributions may not belong to you until a certain period of time has passed (your own contributions are always 100 percent vested). Check with your employer's HR department about matching contributions and any rules that may apply.
Avoid withdrawals if you can
Generally, you can't withdraw from a 401(k) before a specified age without a specific reason. The IRS lists some of them, which include suffering financial hardship (if your employer's plan allows hardship distributions). Certain medical expenses, burial and funeral expenses, and certain home repairs are examples of potential hardship withdrawals.
Avoid withdrawing from your 401(k) if you possibly can. Early withdrawals may set back your preparations for retirement, and are subject to penalty tax in many cases, according to FINRA.
In many cases, if you withdraw from your 401(k) early, you not only pay income tax on the withdrawal, but also an extra 10 percent penalty tax. So whenever possible, it's best to leave your 401(k) balance alone to grow.
Reassess your 401(k) if you change jobs
When you change jobs, you might find yourself with two 401(k) plans — your new employer's and your old employer's.
Don't forget about your old 401(k) accounts — it's your money!
What can you do with your 401(k) if you change jobs?
If you’ve participated in an employee-sponsored 401(k) plan and you’re changing jobs, you have a few options of what you can do with your retirement plan:
- Keep it with your former employer's plan
- Move it to your new employer’s plan (if offered)
- Roll it into an individual retirement account (IRA)
- Cash it out (with tax penalties)
Here are a few considerations that may help you decide which option is best for you.
Keeping your 401(k) with your former employer
You may be able to keep your 401(k) with your old employer's plan, says the Financial Industry Regulatory Authority (FINRA), an independent regulator for U.S. securities firms. You won't be able to make new contributions to the plan (or receive a company match), but you may want to keep the plan if it has provided strong returns with reasonable fees, the agency says. However, the details on whether you qualify to stay on the plan, and how the plan will function once you leave the company, will vary, so talk with the plan's administrator before you decide. A perk of this option: You can still move your money to a 401(k) or another type of tax-deferred account at a later time, according to FINRA.
Move your 401(k) to your new employer
You may choose to transfer your old 401(k) to your new company's plan. Moving your 401(k) to your new company's plan allows you to consolidate your retirement funds into a single account, making it easier to track your assets, according to FINRA. You'll likely want to consider a direct rollover from your old 401(k) to the new plan. You'll need to work with the administrators of each plan to properly transfer funds. Otherwise, if you decide to do an indirect rollover, your fund could be subject to a 20 percent withholding, and an additional 10 percent federal tax if you do not deposit your funds into the new account within 60 days, according to FINRA.
Roll over your 401(k) to an IRA
You may want to consider moving your money into a tax-deferred account like an IRA. You can ask your old plan's administrator to do a "direct rollover," transferring funds directly into an IRA for you. Or, you can do it yourself and have the funds paid out to you (what's known as an "indirect" rollover). If you choose the latter, your old company will be required to withhold 20 percent and you'll only have 60 days to get the funds into an IRA, according to the IRS. If you complete the rollover within the set time period (and with the full balance of your original 401(k)), you can recover the 20 percent when you file your taxes for the year, says FINRA.
Cash out your 401(k) early
While this option may seem simplest — you ask your plan administrator to write you a check for the amount in your 401(k) — it's also the least appealing. That's because you'll not only be cashing out money you had designated for retirement, you'll also be taking a big tax hit on the funds. Your plan administrator will have to withhold 20 percent as an "early tax payment," and, depending on your age, you may also face a 10 percent early-withdrawal penalty from the IRS, and additional taxes from federal, state and local authorities, says FINRA. Bottom line: You may end up with a lot less money than you expect.
Whether you choose to revisit your 401(k) yearly or every six months, it's basically a chance to examine your investments and readjust them to maximize your return. When you're choosing how to allocate your money, it’s typically recommended to consult the advice of a financial professional.