7 401(k) Rules You Should Know by Heart

By Markets Fool.com


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With pensions now a thing that most of us can only wax nostalgic about, 401(k)s have become critical parts of many retirement plans. If you want to make the most of the 401(k) plan available to you, here are seven valuable rules to keep in mind.

Max out employer matches

First off, be sure to grab any available matching funds from your employer. A common employer match is 50% of the contributions you make up to 6% of your salary. Thus, if you contribute 6%, your employer will chip in an additional 3%. Illustrating that with dollars, if you earn $75,000 and contribute 6%, or $4,500, your employer will add another $2,250 -- that's $2,250 of free money, a guaranteed 50% return on your investment. Even if you don't contribute as much as you're allowed to to your 401(k) account, contribute enough to get all the free money you can from your employer.

It can be risky to have too much riding on your employer. Image source: Pixabay

Be careful with stock in your employer

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Many employers make it easy to invest in company stock with your 401(k) contributions -- and some will make their matching contributions in the form of company stock. There's a clear upside to being an investor in your employer. For example, in many ways, it will be the company you know best. There are dangers, though. Remember -- even great companies can fall on prolonged hard times -- or can fail. And your employer already provides much, if not most, of your financial support. If you're depending on your employer for your income as well as relying on it for your retirement, you've got a lot of eggs in that one basket. Try not to keep too much of your net worth in company stock -- perhaps not more than 10%, at most.

View your 401(k) as part of your overall portfolio

Next, don't think about your 401(k) as separate from the rest of your retirement planning and saving. You likely have a regular, non-retirement investment account at a brokerage -- or several of them. You may have one or more IRAs, too. Perhaps you also have some mutual fund investments held at one or more mutual fund companies, and maybe some bonds.

When you have money to sock away each year, think strategically about where it would be best deployed. Your 401(k) may or may not be the best place for all that money. For one thing, 401(k)s typically have a limited menu of investment options for your money. If your 401(k) offers one or more inexpensive broad-market index funds, that might be all you need. But if you'd like to invest in some individual stocks or different mutual funds, you may need to do that outside your 401(k), such as in an IRA. For some people, a good strategy is to first contribute enough to max out matching 401(k) funds, and then to funnel next dollars into an IRA until reaching the maximum IRA contribution (which is $5,500 in 2016 for most people and $6,500 for those 50 and older). Any further dollars after that can go into the 401(k) -- or some other account.

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Save aggressively for maximum results

Speaking of maximum contributions, 401(k) accounts can receive many more dollars each year than IRAs can. The contribution limit in 2016 is $18,000 for most people, plus an additional $6,000 for those 50 or older, giving older savers a hefty maximum of $24,000. Since you probably want to enjoy as comfortable a retirement as possible, it's smart to sock away as much as you can beginning as soon as you can. The table below shows how effective it is to make bigger annual contributions and to do so for as many years as possible.

Growing at 8% for

$5,000 invested annually

$10,000 invested annually

$15,000 invested annually

15 years

$146,621

$293,243

$439,864

20 years

$247,115

$494,229

$741,344

25 years

$394,772

$789,544

$1.2 million

30 years

$611,729

$1.2 million

$1.8 million

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Consider the Roth 401(k) if you can

You may not realize it, but just as there are two main kinds of IRAs -- traditional and Roth -- many companies now offer their workers two different kinds of 401(k)s, also traditional and Roth. With a traditional IRA and 401(k), you contribute pre-tax money that reduces your taxable income and, therefore, your tax bill for the year. When you withdraw the money in retirement, it's taxed as ordinary income. With the Roth IRA and 401(k), you contribute post-tax money that doesn't deliver any upfront tax break. But you eventually get a big tax break when you withdraw from the account in retirement -- because you get to take all the money out of the account tax-free if you follow the rules.

Favor lower fees for higher returns

Unbeknownst to many 401(k) investors, there are typically fees involved, and sometimes hefty ones. That's a big problem, because while you may be saving aggressively and investing through your 401(k), if you're being charged sizable fees, you're fighting against a headwind. (Some plans charge big fees even for index funds that you can invest in elsewhere for a pittance.) Fortunately, the trend is in workers' favor, as fees have been falling in recent years, in part due to lawsuitsbrought about against some employers. A Wall Street Journal articleearlier this year noted that, "According to Vanguard Group, investors in a plan that charged 0.25% a year could in theory amass 20% more money over a four-decade career than they could in one that charged 1.25%, all else being equal." You can look up ratings for many companies' 401(k) plans at www.brightscope.com, where it rates them on fees, among other things.

Don't cash out your 401(k) prematurely. Image source: Getty Images

Don't cash out or borrow from your 401(k)

Finally, don't be one of the many people who cash out their 401(k) account every time they change jobs. Sure, you may have only worked at a given company for three years and may not have much in your account, but if you remove even $20,000 that could have kept growing for you for another 25 years, you could lose out on about $137,000 retirement dollars (assuming an 8% average annual growth rate). Similarly, don't borrow from a 401(k) plan, either, unless it's an emergency and you really have no better option. That's another way of stealing from your financial future.

Social Security will be a welcome help in retirement for many of us, but it's not likely to make us very comfortable. We need to take control of our financial future -- in part by making the most of our 401(k) accounts.

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Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.