Written by: Danny Kofke, Motivational Mentor
Very few companies offer pensions these days, which has given rise to employer-sponsored 401k programs. These allow employees to contribute a percentage of their paycheck each pay period and have that money invested in long-term growth funds. In some cases, your employer may match your contributions (up to a certain annual maximum), potentially doubling your retirement savings. Just remember that since traditional 401k contributions are invested pre-tax, it means that you will need to pay taxes whenever you withdraw the funds in retirement.
However, if you have an existing 401k, you might already know all of this information. That said, it is always a good idea to understand exactly how your 401k works and what you can do to get the most out of it. In today’s article, we are going to take a closer look at 5 things you probably don’t know about 401k!
You may need to put in more than the default contribution
Numerous companies have started auto-enrolling employees in their 401k programs. So, if an employee prefers not to invest, they have to opt out of the benefit. This means that more employees are staying in because it is the easier (and more lucrative) option, which is a good thing for the financial wellness of America’s workforce. In fact, about 62% of businesses with 401k benefits used auto-enrollment as of 2020, greatly increasing participation and helping replace the outdated pension system.
Auto-enrollment typically starts at 3% (i.e., the employee contributes 3% of each paycheck). This may work well for some employees, but it may not be enough for others. Since you are saving for retirement with a 401k, it is important to run the numbers to make sure you are growing your savings and reaching your retirement goals. In some cases, this may require you to contribute more than the default amount.
What you are investing in may not be right for you
With auto-enrollment, your employer chooses a default fund. Many companies pick a “target date fund” that reallocates investments each year to become increasingly conservative as retirement approaches, thereby reducing risk over time. If you are someone who is willing to take on more risk, you may want to choose a different type of fund for your portfolio. Alternatively, if you want to take on virtually no risk, you will need to know exactly what you are investing in and choose low-risk funds from the start (though this will likely reduce your long-term growth potential).
An employer 401k is not free
Unbeknownst to many employees, 401k plans charge fees to participate. Therefore, it is very important to check out the fee structure when you enroll. Oftentimes, bigger companies incur fewer fees, but this is not always the case. Each employer must check how much goes toward fees to help save costs for themselves and their workforce. Usually, these fees are reasonable, but investment management and administrative fees can still take a substantial chunk out of an employee’s retirement savings.
There might be an option to invest in a Roth 401k
With a Roth 401k, funds are invested after taxes have already been taken out. Many people prefer this option because withdrawals during retirement are tax-free, making a Roth 401k a good hedge against the risk of higher taxes in the future. That said, no one knows exactly what the tax bracket will look like years from now, so there is no guarantee that it will save you money on your taxes. In any case, if you prefer to pay the taxes now, a Roth 401k is the better option for you. Even if you prefer to stick with a traditional 401k, it is always good to know when you have alternative options. You may change your mind in the future, in which case you can roll your 401k over into a Roth account.
You can take a loan on your 401k
At Mentoro, we don’t necessarily recommend taking out loans on your 401k unless it is absolutely necessary. In fact, some 401k plans will not allow loans unless you qualify for a hardship withdrawal due to financial setbacks, medical bills, or similarly high expenses. You can usually take up to 50% of your balance or up to $50,000.
But again, this does not apply to all plans. With most plans, you will have to pay back the loan within 5 years. You will have to pay it back in post-tax dollars, and you may have to pay interest. If you have a traditional 401k, you will still have to pay taxes when you withdraw funds during retirement, which can make 401k loans a very costly option. Consequently, taking a loan on your 401k should only be reserved for emergency situations.
The Bottom Line
More than anything else, both employees and employers need to be informed about 401k programs and how they work. It is especially important for employees to empower themselves with knowledge and really get to know their own investment and savings plans. When you understand the benefits at your disposal, you are far more likely to make informed decisions that will help keep you financially stable and grow your wealth for the long term.
If you want to learn even more about 401k programs and benefits, be sure to contact the experts at Mentoro today!