Make sure you know how these 401(k) facts affect you. Image source: Getty Images.
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The 401(k) is the de facto retirement savings device for millions of Americans. With the baby boomer generation starting to retire in huge numbers -- around 3.5 million per year for the next 15-plus years -- it's critically important for this group to understand how their 401(k)s work.
There are several important facts about 401(k) plans that a lot of people don't know. So, baby boomers, take note: Retirement is inching closer and the following four facts matter a lot for you.
Fact 1: The contribution limits can vary
Most people can contribute up to $18,000 to their 401(k) each year. But if you're 50 or above, the IRS allows you to make "catch-up" contributions -- as much as $6,000 extra each year. This is particularly handy if you didn't contribute as much as you should have when you were younger, but you don't actually have to be "behind" in order to make "catch-up" contributions; you just have to be at least 50 years of age.
In 2016, yours and your employer's combined contributions cannot exceed the lesser of$53,000 ($59,000 including "catch-up" contributions) or your total compensation. However, there are cases when your employer may limit your own contributions to an amount that is less than the IRS maximum.
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Bottom line: If you're planning to increase your 401(k) contributions down the road, then you may find you're unable to if your employer has caps in place that are below the IRS limits. It's always a good idea to speak with your human resources department and make sure you know your employer's limits in addition to the IRS limits each year.
Fact 2: Take out money early, pay a penalty (with a few exceptions)
The 401(k) is designed to provide income in retirement, and if you take a distribution before 59-1/2 (excluding rollovers to an IRA or another 401(k)), then you'll be subject to a 10% early-withdrawal penalty, in addition to income tax, on the amount of the distribution. However, the IRS does recognize that there are times when tapping the assets in your 401(k) early is necessary, so it allows some exceptions to the penalty. Here are the key exceptions, straight from the IRS:
A distribution is deemed to be on account of an immediate and heavy financial need of the employee if the distribution is for:
Expenses for medical care previously incurred by the employee, the employee's spouse, or any dependents of the employee or necessary for these persons to obtain medical care;
Costs directly related to the purchase of a principal residence for the employee (excluding mortgage payments);
Payment of tuition, related educational fees, and room and board expenses, for the next 12 months of postsecondary education for the employee, or the employee's spouse, children, or dependents;
Payments necessary to prevent the eviction of the employee from the employee's principal residence or foreclosure on the mortgage on that residence;
Funeral expenses; or
Certain expenses relating to the repair of damage to the employee's principal residence.
While these exceptions may protect you from the early-withdrawal penalty, you must still pay income tax.
Fact 3: Roth and traditional contributions change your taxes
While the Roth IRA has been around for decades, the Roth 401(k) is a more recent offering that's becoming popular. However, it may not necessarily be the best choice for you.
The key differences between regular and Roth 401(k) contributions are simple: When you pay tax on the money in the account. Traditional 401(k) contributions are made pre-tax, meaning you'll save money on your taxes in the year you make the contribution. With Roth contributions, you still pay income tax on those earnings this year, but your qualified distributions will be tax-free.
If your effective tax rate today is higher than you're likely to pay in retirement, then you may be better off making traditional 401(k) contributions now. If your tax rate today is lower, then Roth contributions probably make more sense. (Read this article for more on understanding your effective tax rate.) A Roth also makes sense if you'd rather eliminate the risk that federal income taxes will rise in the future, eventually taking a big bite out of your retirement savings.
Fact 4: You pay fees. No, really
You may think that you don't pay any fees in your 401(k). After all, you never see a bill, right? But don't let the lack of an invoice lead you astray: You are most assuredly paying fees to the mutual fund managers who invest your money for you.
How do you find out how much you're paying? It's pretty easy. Log into your 401(k) website (if you don't know how, then an HR employee should be able to help you out) and find the prospectuses for the mutual funds you are invested in, then locate theexpense ratio. This is basically the annual percentage rate the fund manager charges to operate the fund.
The managers remove their cut directly from the fund -- hence the lack of an invoice.But you're still paying fees.
Why do fees matter? Because high fees not only eat into your returns (leaving you with less money when it's time to retire), but there's also evidence that high-fee mutual funds tend to underperform funds with lower fees. In other words, if you're invested in higher-fee funds, you may be paying a premium for sub-par investing results.
The article 4 Facts about Your 401(k) Every Baby Boomer Should Know originally appeared on Fool.com.
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