Personal Finance 101: Understanding the Ins and Outs of a 401(k)

By Sean Williams Markets Fool.com


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There's no doubt about it: The employer-sponsored 401(k) is the most popular retirement tool for working Americans. According to data from StatisticBrain.com, as of 2015, 18% of all retirement assets were being held in 401(k)s, with the value of those assets totaling $4.5 trillion. On average, 81.5% of workers who have a 401(k) plan offered through their employers are participating, with the average contribution working out to 6.8% of their salaries.

Yet despite its popularity and the perceived satisfaction of 401(k) plans among working Americans, surveys demonstrate that workers' knowledge of 401(k) plans is often lacking. The 2015 "RetireWell Study" from Guardian Insurance and Annuity Company found that many of its 2,000 surveyed employees were unaware of basic investing concepts, which could keep them from maximizing the potential of their 401(k) plans.

Understanding the ins and outs of your 401(k)

If there's a silver lining here, it's that bridging the knowledge gap isn't difficult as long as workers are willing to seek out the information and/or employers are eager to supply it to employees. Here are some of the core ins and outs of employer-sponsored 401(k)s that workers really need to know.

How do I enroll in a 401(k)?

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More and more employers are taking it upon themselves to automatically enroll workers in a company 401(k) plan, thus requiring workers to take action only if they don't want to participate. The reason employers do this is because procrastination keeps workers unnecessarily on the sidelines. By automatically enrolling workers, employers are giving them the kick in the behind they probably need to get on the right track to build their nest eggs.

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According to a study from Towers Watson that was released in 2014, the number of businesses offering automatic enrollment to new hires jumped from 57% in 2010 to 68% by 2014. In other words, automatic enrollment in 401(k)s appears to be a powerful tool to encourage participation.

If you have a 401(k) plan offered at your workplace, but you're not automatically enrolled, you should be able to complete the enrollment process with your company's human resources representative, or through a company website.

How much can I contribute annually?

Probably the biggest question on the minds of workers is how much can they contribute each year. For workers under the age of 50, the maximum contribution in 2017 is $18,000. For those aged 50 and up, the maximum contribution jumps to $24,000. The $6,000 difference is known as the catch-up contribution, and it's there to help give an extra boost to workers who'll soon be entering retirement.

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What's really notable about 401(k)s, and likely why they're the go-to retirement tool of most workers, is their annual contribution limits. At $18,000/$24,000, the 401(k) absolutely dwarfs the maximum annual contribution limit of Individual Retirement Accounts (IRAs) at $5,500 for those aged 49 and under, and $6,500 for seniors ages 50 and up.

One added bonus of a 401(k) is that, as long as you're working, there's no age restriction as to who can contribute, similar to a Roth IRA. Traditional IRA contributions must cease in the year an individual turns 70-1/2 years old.

How do 401(k) contributions affect my taxes?

Contributing to a 401(k) can also have a pleasant or unpleasant impact on your taxes. Money contributed to a 401(k) is taken directly from your paycheck on a pre-tax basis, meaning it can help lower your current-year tax liability. Generally, that's a good thing.

However, money in a 401(k) plan also grows on a tax-deferred basis: When you begin taking distributions from your 401(k) during retirement, you'll owe ordinary income tax on that money. If retirees are unprepared, this added income from a 401(k) can push them into a higher tax bracket, forcing them to hand over more of their nest eggs to Uncle Sam.


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Does my company offer a match?

Chances are better than not that, if your company offers a 401(k) plan, it also offers to "match" a percentage of your salary -- as long as you contribute a predetermined amount to your 401(k). Company matches are put in place to help retain talented employees, as well as prepare employees for retirement. The average employer match tends to be about 3% of an employee's salary.

If you work for a company that offers a match, passing it up is akin to turning down free money. Sure, there's a high likelihood that you won't be able to touch this free money until you retire without paying a penalty, but your company is essentially offering you extra money to encourage you to save for your own retirement! While most companies offer dollar-for-dollar matches, some companies are even more generous. For example, oil producer ConocoPhillips (NYSE: COP) offers to match 9% of an employee's salary per year as long as they contribute just 1%!

Long story short, don't turn down free money.

What are my investing options?

A 401(k) plan may offer the juiciest annual contribution limits and the prospect of an employer match, but one of its downsides is that your choices could be limited. Employers often contract their 401(k) plans with a single financial firm, leaving the employee to choose between a relatively small number of mutual fund options.

According to the Plan Sponsor Council of America, the average 401(k) plan in the U.S. offers about 19 different mutual funds to choose from. By comparison, if you invest in an IRA, you'd probably have your choice of about 7,000 different assets, including individual stocks and electronic-traded funds (ETFs).

What fees and penalties should I be aware of?

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If you choose to participate in a 401(k) plan, you should also be aware of the annual fees and penalties you could potentially face. To begin with, money managers charge a fee annually to run a mutual fund. Additionally, marketing, bookkeeping, and legal fees -- just to name a few fees -- are usually rolled into 401(k) fees. Per Robert Hiltonsmith of the public policy research group Demos, 401(k) fees could wind up eating 30% of your 401(k) by the time you retire.

On top of management fees, pulling money out of a 401(k) prior to hitting age 59-1/2, the first eligible age to begin making withdrawals from a 401(k), will likely result in a 10% penalty, as well as the need to pay ordinary income tax on the money withdrawn. There are a small handful of exemptions that allow you to avoid the 10% penalty and withdraw your money before turning age 59-1/2. Examples include becoming totally and permanently disabled, or paying unreimbursed medical expenses exceeding 10% of your adjusted gross income. But generally speaking, pulling your money out early will probably necessitate a 10% penalty and ordinary income taxes.

What happens when I begin taking my 401(k) distributions?

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Finally, the greatest question of all: What happens when you begin taking your distributions? For starters, you can begin taking withdrawals at age 59-1/2, though you can also choose to wait.

Assuming you're not still working, you must begin taking distributions by age 70-1/2, or you could face a nasty penalty. Once you reach age 70-1/2, there's a required minimum distribution (RMD) that must be taken each year. If you fail to take out the RMD, the amount not withdrawn is taxed at an unpleasant 50%!And as stated earlier, once you begin taking distributions from your 401(k), you'll be responsible for ordinary income taxes on that cash.

As the saying goes, "knowledge is power." The more you know about 401(k)s, the better your chances of maximizing your return potential and setting yourself up for a comfortable retirement.

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Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has adisclosure policy.