The 401(k) Cheat Sheet…

…and 403(b) Plans & 457 Plans

First things first, a 401(k) is NOT an investment. It is a TYPE of qualified retirement account. You, as the participant of the company retirement plan, must choose HOW to invest your money within the 401(k) account.

When you start a job at a mid-sized or larger private employer, chances are you will be offered a 401(k) account as a way to save for retirement. These tax-advantaged plans allow you to put money aside through payroll deductions. Since its inception 40 years ago, the 401(k) has become the retirement plan of choice for most employers, largely replacing traditional pension plans.

To encourage employees across the company to get started saving money, many companies offer “match” programs: basically, if you save some money in your 401(k), your employers will give you additional money – to put in that account.

Tax Break: Reduce taxable income when contributing to a 401(k)

The core of the 401(k)’s appeal is reducing your taxable income. The funds for it come from your salary, but before tax is levied. This lowers your taxable income and cuts your tax bill in the year that you contribute.

Say you make $8,000 a month and put $1,000 aside in your 401(k). Only $7,000 of your earnings will be subject to tax. Plus, while inside the account, the money grows free from taxes.

Yes, you will have to pay taxes someday. That’s why a 401(k) is a type of tax-deferred account, not tax-free.

401(k) is a qualified retirement account, just like an IRA. The difference being how much you can contribute annually.

Contribution Limits

Since the 401(k) is a powerful savings tool, the IRS sets an annual limit on how much money you can set aside in a 401(k). That amount is adjusted every year for inflation. For 2023, the contribution limit is $22,500.

If you’re 50 or older by year-end 2023, you can contribute an extra $7,500, for a total of $30,000. If you cann’t afford to contribute the maximum, try to contribute at least enough to take full advantage of an employer match (if your company offers one).

401(k) Plan Fees

Unfortunately, 401(k) plans come with fees, but study after study reveals that many savers don’t realize this, or if they do, don’t know how to find out what the fees are for the plan they participate in. Typically, fees will range from 0.5% to 2% of the plan assets.

Pay attention to each fund’s expense ratio, which is a measure of a fund’s operating expenses expressed as an annual percentage. The lower the expense ratio, the less you’ll pay to invest. A total expense ratio of 1% or less is reasonable. Look at your 401(k) plan’s website to find a fund’s expense ratio.

The good news is that your plan may give you access to lower-cost institutional shares, which are cheaper than different share classes of the same investment bought through an independent retirement account (IRA). One way to cut costs: Look to see whether your plan offers index funds, which tend to be cheaper than actively managed funds.

Investment fees run with each fund, so you have some control over them based on your choices. You have less say in “plan administration fees” – which are the costs of running the entire program that your company has chosen.

Fund Selection

In a 401(k), your employer will select the investment choices available to employees. You, as the employee, can then decide how to allocate your contribution among those available options. If you don’t make a selection for your contribution, your money will go to a default choice, likely a money-market fund or a target-date fund or a balanced fund.

Most plans will offer actively managed domestic and international stock funds and domestic bond funds, plus a money-market fund. Many plans also offer low-cost index funds.

Increasingly popular on the 401(k) menu: target-date funds, which nearly 70% of plans offer. Over time, this breed of fund typically shifts from a stock-heavy portfolio to a more conservative, bond-heavy portfolio by its target date.

If you need guidance, it is recommended that you consult with a professional. If you don’t work with a financial advisor, oftentimes the Company Retirement Plan has an Advisor that is available to assist the participants. It is recommended to work with a dedicated financial advisor that can tailor their advice to your personal needs and goals.

Your Plan Might Let You Choose Individual Stocks in Your 401(k)

While many employees are fine choosing from limited range of funds, the self-directed brokerage account (SDBA), has been gaining popularity, with about 40% of companies offering these options. They let participants invest in a much broader menu of mutual funds, ETFs and, in some cases, individual stocks.

As is the case with an IRA, you can trade stocks and funds in your 401(k) willy nilly without reporting gains and losses to the IRS when you file your tax return. But if you want an SDBA there may be additional fees and costs. Companies may choose to levy an annual maintenance fee, plus transaction fees if you use the account to trade stocks or funds.

The Roth 401(k) Option

Another choice to consider: a Roth 401(k), which many plans offer. As with a Roth-IRA, you are allowed to put in after-tax money in exchange for tax-free growth and tax-free withdrawals in the future.

Things get a little trickier if your employer offers a 401(k) match, as (for now) the match can only go into a traditional 401(k). The solution is to have one of each so you get your match.

One significant difference from a Roth IRA is that there are no income limits on Roth 401(k) contributions, so these accounts provide a way for high earners to access a Roth option.

Roth-IRA is the same concept as Roth-401(k).

You Can Roll Over a 401(k) Account

Workers generally have four options for their 401(k) when they leave a company: You can take a lump-sum distribution; you can leave the money in the 401(k); you can roll the money into an IRA; or, if you are going to a new employer, you may be able to roll the money to the new employer’s 401(k). It’s important to keep your retirement savings in qualified retirement accounts to maintain their favorable tax advantages. Make sure you consult with a professional when performing a rollover to ensure that you maintain the qualified status.

Eventually You Must Withdraw Money from a 401(k)

Uncle Sam won’t let you keep money in the 401(k) tax shelter forever. As with IRAs, 401(k)s have required minimum distributions (RMD’s). You must take your first RMD by April 1 in the year after you turn 72. You will have to calculate an RMD for each old 401(k) you own (oftentimes the custodian of your assets will provide this calculation for you). Once you’ve determined the RMD, the money must then be withdrawn separately from each 401(k). Note that unlike Roth IRAs, Roth 401(k)s do have mandatory distributions starting at age 72.

If you hit that magic age, you are still working, and you don’t own 5% or more of the company, you don’t have to take an RMD from your current employer’s 401(k). And if you want to hold off on RMDs from old 401(k)s and IRAs, you could consider rolling all those assets into your current employer’s 401(k) plan.

Taking a Loan from Your 401(k)

Some plans allow for participants to take loans against their 401(k). In some instances it can be an appealing option, with interest rates usually set at the prime rate plus one percent. Plus, that interest goes back to you, since you’re borrowing from yourself. Win-win, right?

First, of all, as with any debt, you should think hard about why you’re taking it on and how you’re going to pay it back. Additionally, there are limits set by the IRS rules that govern 401(k)s: generally, the lesser of $50,000 or 50% of the account balance. Unless they’re for a primary residence, 401(k) loans must be repaid within five years payments must be made at least quarterly. And here’s a big catch: Remember that 401(k) plans are tied to your employment and your employer. Same goes for the loans. If you leave your job, you generally have to pay back the loan within 30 to 60 days of your last day on the job or you’ll owe taxes on the balance plus a 10% penalty if you’re younger than 55.

Finally, you should also consider opportunity cost: You may be paying yourself 5% interest, but how much more could that money have been making if you’d left it invested?

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