3 Things You Didn't Know About Your 401(k)

By Markets Fool.com

Image source: www.TaxCredits.net via Flickr.

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More than 73 million American workers actively participate in a 401(k) or similar retirement plan, yet many of these individuals don't fully understand how it works. There have been many articles published on the various investment options available in 401(k) plans, but here are three things you might be surprised to learn.

1. You can contribute more than you think
The majority of employees contribute enough to their 401(k) to take full advantage of their employer's matching contributions. While this is an excellent starting point, you can (and should) be saving more.

It may surprise you to learn that for 2016, you can choose to defer up to $18,000 of your compensation to your 401(k), and an additional $6,000 if you're 50 or over. This doesn't even include the money your employer puts in or any mandatory contributions -- just elective deferrals.

Now, I realize it may not be practical (or necessary) for you to save the absolute maximum, and that's fine. The point here is that you can choose to contribute more, and that a small increase in your savings rate can go a long way.

To illustrate this, let's say you're 35 years old and your salary is $50,000. We'll also say that your employer will match your contributions dollar for dollar up to 5% of your salary. Assuming 8% average annual investment returns and 2% annual raises, just look at the difference an increase can make.

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Your Contribution Rate (% of Salary)

Employer's Contribution Rate

Total Contribution Rate

Account Value at Age 65

5%

5%

10%

$751,673

6%

5%

11%

$826,841

7%

5%

12%

$902,008

8%

5%

13%

$977,175

10%

5%

15%

$1,127,510

So, even though your employer won't contribute any more than 5% of your salary, increasing your contribution rate by a few percentage points can have a big impact on your quality of life in retirement. Of course, there is no way to accurately project 30 years of market returns and wage increases, but the main idea still applies.

2. The funds in your 401(k) have fees attached -- and they may be eating your returns
If you look at the literature you received from your 401(k) administrator, there should be a detailed description of each investment fund offered. Here you should be able to find a number known as the expense ratio of each fund.

An expense ratio tells you how much it costs you to invest in the fund, expressed as an annual percentage of the fund's total assets. This is important to know for two main reasons.

  1. A fund's expense ratio effectively lowers your investment gains. For example, if your fund's stocks gained 5% this year, and it charges a 1% expense ratio, you can expect your shares to appreciate by 4% for the year. Over time, this can make a big difference in terms of your investment performance.
  2. Expense ratios can vary significantly between funds, even those with similar investment strategies.

I want you to be aware of the true cost of investing, because even a small difference in fees can result in thousands of dollars in additional retirement savings. Here's a more in-depth look at why you should compare the fees before you choose your 401(k) investments.

3. You may be able to withdraw your money before age 59 1/2
In general, you need to be at least 59-1/2 years old before you can take money out of a tax-deferred retirement account such as a 401(k) without paying a 10% early withdrawal penalty. However, there are a few exceptions.

One exception you need to be aware of is the "separation from service" rule, which says that if you are no longer at your job, you can withdraw the money in your 401(k) account as early as age 55. Note that this exception doesn't apply to IRAs.

Or, if you agree to withdraw your money in "substantially equal payments" spread over your expected lifespan, you can start taking money out penalty-free. For example, if you're fortunate enough to retire at 50, you can begin to take annual payments from your 401(k) as determined by IRS life expectancy guidelines.

There are a few other reasons you can use your 401(k) funds early:

  • If you become totally and permanently disabled.
  • To pay unreimbursed medical expenses exceeding 10% of your adjusted gross income.
  • If you're a qualified military reservist called to active duty.

Do you know why it's so important?
One final fact I'd like to emphasize: The stock market has historically produced total returns of more than 9% per year, on average. This isn't a 401(k)-specific fact, but it's an important one to know.

It's important to know because the majority of your 401(k) assets are likely invested in stock-based mutual funds, and the more you contribute, especially while you're younger, the more powerful the returns of the stock market can be for you.

Consider the case of a 30-year-old who contributes $5,000 per year to his/her 401(k) each year, including employer matching. By this worker's 65thbirthday, she will have put a total of $175,000 into her 401(k). Based on the stock market's average rate of return, how big of a nest egg could she retire with? $300,000? Maybe $500,000?

It may surprise you to learn that the account could swell to more than $930,000, and that's based on a historically conservative 8% return rate. The point is that it's important to learn about your 401(k) and its investment options, as it has the power to produce the retirement of your dreams, if you'll let it.

The article 3 Things You Didn't Know About Your 401(k) originally appeared on Fool.com.

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